WORK BOOK

Working Capital Management and Finance

1. Meaning of Working Capital

Working capital means the fund available for meeting the day-to-day requirements of
an enterprise. A part of the fixed or permanent capita is invested in fixed assets (assets
which are kept in the business for a long period or permanently for earning profit like
land and building, plant and machineries, intangibles like goodwill, patents etc.). The
other part of the permanent capital, left in the business for supporting day-to-day
normal operations, is known as working capital.
Thus, Working Capital is a part of the total assets of a business which changes from
one form to another in the ordinary course of business operations. Every organization
needs to maintain an optimum level of working capital by bringing trade-off between
risk and profitability.

2. Concept of Working Capital

 Traditional or Balance Sheet Concept
 Operating Cycle concept

According to Balance Sheet Concept working capital is calculated on the basis of the
balance sheet prepared at a specific date depicting the position of the firm at a certain point in
time and working capital is of two type s:

i) Gross Working Capital ii) Net Working Capital

Gross Working Capital – Gross or total Current assets representing funds available for
operations

Net Working Capital - Excess of total current assets over total current liabilities measuring
the Organization’s liquidity indicating the extent to which working capital can be financed
with long term funds
 Debtors and Bills Receivables Sales

Finished Goods

CASH

Raw Materials Work- in - Progress

Operating Cycle

The time required to complete the sequence of events like right from purchase of raw
materials to realization of sales in cash is called operating cycle or working capital cycle. The
amount of working capital required depends on the length of net operating cycle and
operating expenses needed for the period.

So, according to the operating cycle concept working capital is the amount required in
different forms at successive stages of operation during the net operating cycle period.

3. Type of Working Capital on the basis of time

Permanent and Temporary (variable) Working Capital:

With reference to time or behaviour, the need for working capital may be of two types:

i) Permanent of Fixed
ii) Temporary or variable
Permanent working capital refers to the minimum level of investment in the form of working
capital required permanently to operate at a minimum level of activity. This is generally
financed from long term sources.

Temporary working capital is generally financed from short- term sources. This is actually
fluctuating in nature and needed over and above permanent working capital. The need for
this type of working capital varies with the fluctuation in the volume of activity over and
above a minimum one. For example: firms dealing with seasonal products require more
temporary working capital. Seasonal working capital includes the additional sum a firm
requires to function during the peak season, which is related to the seasonal demand for
items. It may also be thought of as a flexible form of operating capital. Whereas, to meet
unforeseen circumstances of economy, demand of output, availability of inputs etc., calls for
keeping aside the working capital known as specific working capital.

Profitability or Profit earning capacity of a firm indicates efficiency and it can be measured
by ratios like Gross profit to net sales, Profit to capital employed, Profit after tax to net worth.

When we use profit to capital employed, here capital employed – capital employed represents
fixed asset plus working capital

Profitability = (Profit / sales) x (sales/ capital employed)

When return on capital employed is used as the measure of profitability, the relation between
profitability and liquidity follows from the component of the ratio

Profitability = profit / (Fixed assets + working capital)

This means keeping other things constant, more and more reduction in the amount of working
capital will lead to improved profitability ratio and vice versa

It is usually assumed that there is always a negative relation between liquidity and
profitability although it cannot be denied that unless there is a minimum level of investment
in the current assets which provide a promising vehicle for increasing profitability, output and
sales cannot be maintained. So, up to a certain level they are complementary. Up to a certain
level increase in liquidity leads to increase profitability, beyond that profitability remains
constant with increase in liquidity up to a certain point, after that, any further attempt to hold
more current assets will lead to decline in profitability.
 4. Forecasting Working Capital Requirements:
To ensure proper financing mix, one has to plan working capital requirement in
advance. The factors to be considered while determining the working capital
requirement of the firm include
 Nature of business
 Production Cycle
 Business Cycle
 Seasonality and production policy
 Credit policy
 Growth and expansion
 Rise in price level
 Operating efficiency
 Availability of raw material
 Depreciation policy
 Taxation
 Dividend policy and retention policy

5. Estimation of Working Capital Needs

Some important methods of estimating working capital needs are:
(i) Operating cycle method, (ii) Estimation of current assets and current liabilities
method, and (iii) Cash forecasting method.

Illustration I

Himanshu Ltd.’s Profit and Loss Account for the year ended 31st December 2020 is given
below. You are required to calculate working capital requirements under operating cycle
method.

Trading and Profit and Loss Account

 For the year ended 31st December 2020

Particulars Rs. Particulars Rs.

To Opening Stock: By Sales (Credit) 1,00,000
Raw Materials 10,000 By Closing Stock:
Work-in – progress 30,000 Raw Materials 11,000
Finished Goods 5000 Work – in - Progress 30,500
To Purchase ( Credit) 35,000 Finished goods 8,500
To Wages & Mfg. Expenses 15,000

To Gross Profit c/d

55,000
150,000 1,50,000
To Administrative Exp. 15,000 By Gross Profit b/d 55,000
To Selling and Dist. exp 10,000
To Net Profit 30,000
55,000 55,000

Opening and closing debtors were Rs. 6500 and Rs. 30,500 respectively, whereas opening
and closing creditors were Rs. 5000 and Rs. 10,000 respectively. Assume 365 days in a year.

Solution:

a) Raw material storage period =

(Average Stock of raw materials / Daily average consumption)
Raw materials consumed = opening stock+ purchase – closing stock
= 10,000+35,000 – 11,000
= 34,000 Rs.
Average daily consumption = 34,000 / 365 =93.15
Average stock of raw materials = (10,000 +11,000) / 2 = 10,500
Raw material storage period = 10,500 / 93.15 = 113 days

b) Conversion or processing period

(Average stock of Work-in-progress / Daily average production cost)
 Calculation of production cost:

Particulars Rs.
Operating work in progress 30,000
Add: Material Consumed (as above) 34,000
Add: wages & mfg. Expenses (15,000) 79,000
Less: Closing Work-in - Progress 30,500
48,500

Daily average production cost = 48500/ 365 = 132.88

Average stock of work in progress = (30,000+30,500) / 2 = 30,250
Processing period = 30,250 / 132.88 = 228 days

c) Finished goods storage period

(Average Stock of Finished Goods / Daily average cost of goods sold)
Calculation of cost of goods sold

Particulars Rs.
Opening stock of finished goods 5000
Add: Production cost (as above) 48,500
53,500
Less: Closing stock of finished goods 8500

45,000

Daily average cost of goods sold = 45000/ 365 = 123.29

Average stock of finished goods = (5000 + 8500) / 2 = 6750
Finished goods storage period = 6750 / 123.29 = 55 days
d) Debtors collection period
(average debtors/ Daily average sales)

{(6500+30500) / 2} / (100000 / 365) = 67 days

e) Creditors payment period
(Average creditors / Daily average purchase)
{(5000+ 10000) / 2} / (35000 / 365)
 = 7500 / 95.89 = 78 days
S0, net operating cycle period = 113+ 228+ 55+ 67 – 78 = 385 days
f) Number of operating cycles per year = 365 / net operating cycle period = 365 / 385
= 0.948

g) Total operating expenses or cost of sales

Total cost of goods sold + administrative expenses + selling and distribution expenses
= 45000 + 15000 + 10000 = 70,000
h) Working Capital Required
= (Total Operating Expenses / Number of Operating cycles in a Year)
= 70000/ 0.948
= Rs. 73,839

Alternative formula: WC = [ { C + ( OC ÷ N) ] × CS
WC = Working Capital, C = Cash balance Required, OC = Operating Cycle
Period, CS = Cost of sales, N = number of days in a year
Hence; WC = 0 + (385 / 365) x 70000 = 73835 (approximation in the number of
operating cycles)

Exercise:
From the following information taken from SNL Company, calculate the working
capital required by the operating cycle method:
I) Annual sales are estimated 100000 units @ 20 per unit
II) Production and sales quantities are coincident and will be carried on evenly
throughout the year and the production cost per material is Rs. 10, labour Rs. 4,
overheads Rs. 4 per unit
III) Customers are given 60 days credit, 40 days credit taken from suppliers
IV) 30 days of supply of raw material and 15 days supply of finished goods are kept in
stock
V) The production cycle is 30 days, materials are issued at the commencement of
each production cycle
VI) A cash balance equal to one-third of the other average working capital is stored
for emergencies
VII) Number of days in a year to be considered 365
 Net current assets forecasting method

Statements showing working capital requirements

Particulars Amount (in Rs.)
(A) Current Assets
i) Stock of raw materials (for … months consumption) ……..
ii) Work in process ( for.. months)
a) Raw material …….
b) Direct labour …….
c) Overheads ……. ……….
____________
iii) Stock of finished goods ( for … months sales)
a) Raw material
b) Labour .............

c) Overheads
…………….

iv) Sundry debtors or receivable ( for … month’s sales) …………… ……………….

a) Raw material ___________

b) Labour
………………
c) Overheads
v) Payments in advance ( if any)
…………….. ………………
vi) Balance of cash ( required to meet day-to-day
……………. ………………
expenses)
……………… ……………….
vii) Others (if any)
Total current assets (A)
……………….
(B) Current Liabilities
i) Creditors (for …month’s purchase of raw materials)
ii) Lag in payment of expenses (outstanding expenses …
month’s)
iii) Others (if any)
Total current liabilities (B)
Net working capital (A) – (B)
 Add: Provision for contingencies
Total Working capital Required
………………….
…………………

…………………
____________ ______________

----------------------

Illustration

Prepare an estimate of working capital requirements from following information of a trading

concern:

(a) Projected annual sales 1,00,000 units

(b) Selling price Rs. 8 per unit
(c) Profit margin on sales 25 %
(d) Average credit period allowed to customers 8 weeks
(e) Average credit period allowed by customers 4 weeks
(f) Average stock holding in terms of sales requirement 12 weeks
(g) Allow 10 % for contingencies

Solution:

COGS

Sales = 100000 x 8 = 800000

Profit = 800000 x 25 % = 200000

Cost of sales = 800000 – 200000 = 600000

Statement of working capital requirement

 (A) Current Assets
Stock (12 weeks)
600000 x (12/52) 138462
Debtors ( 8 weeks)
600000 x (8/52) 92308
Total Current Assets 230770

(B) Less current liabilities

Creditors 4 weeks
600000 x( 4/52) 46154

Net working capital 184616

10% contingencies 18462
203078
Total working capital

Being a trading concern cost of sales treated as purchase

Profit has been ignored as they may or may not be used as a source of working capital

Cash forecasting method:

Estimates of cash receipts and payment is made to get the indication of deficiency or
surplus of cash. The management formulates plans to procure the amount of deficit (a
form of cash budget).

Cash management refers to the collection, management, and investment of company's cash. It
is composed of a range of activities including managing bank accounts, ensuring sufficient
liquidity to meet short-term obligations, optimizing cash flows, and making strategic
investment decisions.
Effective cash management ensures that a business can cover its financial obligations, avoid
excessive debt, and strategically use its cash resources for growth and stability. It involves
practices like forecasting cash flow, managing receivables and payables, and using tools and
strategies to optimize the handling of cash inflows and outflows.

While managing cash, the objectives of liquidity and profitability have to be kept in mind.
Facets of cash management include:

Cash planning – preparing a cash budget with the help of planned cash inflows and cash
outflows to have better insight into cash surplus or deficit

Cash flow management – effective management of cash inflow and outflow. Inflow to be
accelerated and outflow to be decelerated

Determination of optimum level – appropriate level of cash balance to prevent both excess
cash and cash deficit situations

Investment of idle cash – investing idle cash in avenues such as bank deposits and marketable
securities to generate more profit

Optimum Cash Balance

When the cash balances are low, the transaction cost is high but opportunity cost is low. On
the other hand when cash balances increase transaction cost declines and opportunity cost
increases. At a certain point the sum of two costs is lowest and that is the point of optimum
cash balance that should be maintained.

Baumol Model

Proposed by William . J. Baumol and similar to EOQ concept of inventory management.

There are two types of costs associated with cash balance – first is transaction cost incurred
when marketable securities are converted in cash. Second is holding cost i.e. the benefit
forgone due to holding of cash balance. Both of these costs are variable in nature but if one is
reduced the other will increase and vice versa.

C = √ (2bT ÷ I)

C = Optimum cash balance , b = requirement of cash , T = transaction cost , I = interest

rate

Illustration

Monthly cash requirement Rs. 60000; Fixed cost per transaction Rs. 10; interest rate on
marketable securities 6% p.a.

Then the cash balance = √ {(2x 60000x10) ÷ 0.005} = 15492

Miller- Orr model

The Miller-Orr model is a financial model used to determine the optimal level of cash
balances for a firm. It was developed by economists Merton Miller and John Orr in the 1960s.
The model is based on the idea that there are two types of costs associated with holding cash:
transaction costs and opportunity costs. Transaction costs are the costs associated with buying
and selling securities, such as brokerage fees and taxes. Opportunity costs are the potential
returns that could be earned by investing excess cash in securities instead of holding it as
cash.
The Miller-Orr model helps firms determine the optimal level of cash to hold by balancing
the costs of transactions and opportunity costs. The model assumes that firms will have a
target cash balance, above which they will invest excess cash in securities and below which
they will borrow to maintain the target level.
To use the model, a firm first needs to determine its target cash balance, which is the level of
cash that the firm wants to hold to meet its daily cash needs. The firm then needs to estimate
its transaction costs and its opportunity costs. Transaction costs can be estimated using data
on past transactions, while opportunity costs can be estimated using the expected returns on
securities.
Cash Forecasting and Cash Budget

Knowing the difference between estimated net profit from operations and estimated cash
receipts over cash disbursements is of utmost importance in financial forecasting and
planning. The most effective way to help planning for cash requirements and resources of a
business is cash budget.

Cash forecasting may be done either on short term or long term basis.

Short term cash forecast and cash budget:

a) Receipt and disbursement method

b) Adjusted net income method

Format of cash budget (receipts and disbursement method)

(Amount in Rs.)

Particulars/ Month
 1. Receipt:
Collection from debtors
Cash sales
Other income
Total receipts (a)
2. Payments:
Payments to creditors for
purchase
Wages
Factory overheads
Administration overheads
Selling expenses
Machinery or assets
Taxes
Dividends
Other payments
Total payments (b)
3. Net cash balance (c) (a-b)
4. Opening balance
5. Net monthly cash surplus
or deficit (3+4)

Format of adjusted net income method of forecasting cash

(Amount in Rs.)
Particulars/ month
Cash balance at the beginning (A)
Sources:
1. Estimated net income (net profit)
2. No cash transactions:
Depreciation
Amortisation of Expenses
Accruals

3. Decrease in assets:
Accounts receivables
Inventory
Marketable securities
Fixed assets
4. Increase in liabilities:
Accounts payable

5. Increase in Net Worth:

Increase in Capital
TOTAL SOURCES (B) (SUM of 1 through
5)
Applications or Uses
6. Increase in Assets:
Accounts Receivables
Inventory
Marketable securities
Fixed assets
7. Decrease in liabilities:
Accounts payable
Taxes payable
Long term debt
8. Decrease in net worth
Repayment of capital
 Dividend payment out of reserves
Total Uses (C) (sum of 6 through 8)
Cash balance at the end (D) (A+B+C)

Long term cash forecasts and cash budget

Long term cash forecasting is prepared in order to know about the organization’s financial
requirements of distant future and these forecasts may be made for two, three or five years.
The method of short term forecasting viz. receipts and disbursement method is generally used
in long term cash forecasting.

Illustration

The following is the sales forecasting for a corporation. The sales are offered net 30 days.
Eighty per cent of receivables are collected in the month following the month of actual sales
and 10% collected each month thereafter. 15 % of sales are cash sales.

You are required to prepare a schedule of cash inflows for the months of September, October,
November and December.

MONTH Rs. MONTH Rs.

July 900000 October 600000
August 800000 November 580000
September 750000 December 550000

Solution

Cash flow schedule

Month September October November December
Cash sales 112500 90000 87000 82500
(15%)
Account
receivable
(85%)
July: 765000 76500 76500 - -
August:680000 544000 68000 68000 -
September: - 510000 63750 63750
637500
October: - - 408000 51000
510000
November: - - - 3.94.400
493000
December: - - - -
467500
Total cash 733000 744500 626750 591650
inflow

6. Inventory Management
Inventory refers to a list of goods held at different stages for the ultimate purpose of
sale (an accounting term that is considered to be current asset on a balance sheet).
Inventory management’s goal is to minimise the total cost (Direct and Indirect)
associated with holding inventories.

Different forms of inventory:

Raw materials
Work-in- Progress
Finished goods
Stores and supplies

Factors influencing Inventory levels

Rate of inventory turnover – Rate at which inventory is consumed in the production

cycle. When this rate is soaring – investment in inventories is likely to be low and vice
versa.
 Characteristics of Products – For durable goods high level of inventory

For perishable and fashion goods low level of inventory

Market structure – if market is imperfect and demand is indecisive, organization should

keep large inventory of goods to realize the benefit of profitable scopes

Economies of production – it influences cost, amount and quantum of inventory.

Modern machinery is expensive and cost of inoperative machine time is substantial. So
every organization prefers to retain an adequate stock of raw materials to prevent
interruptions in production process

Following are the consequences of over investment:

- Unnecessary blockage of funds in inventory

- Excessive storage is required to store the inventory.

- Excessive insurance cost.

- Risk of liquidity: Value of the inventory reduces due to the long holding period as the
inventories once purchased are difficult to dispose off at the same value.
Following are the consequences of under investment:

- Under investment in the inventory may cause frequent interruptions in production process.

- Insufficient stock of finished goods may create problems in meeting customers’ demands
and they may shift to the competitors.

Cost of Holding Inventories

Refers to the cost incurred in maintaining a desired level of inventory. While determining the
optimum level of inventory two types of costs are taken into consideration which are:

Ordering cost – Cost associated with the acquisition of inventory (to maintain constant
monitoring of stock levels and place orders with suppliers after thorough analysis with
respect to quality, quantity and cost parameters)

Carrying cost – expenses involved in storing goods for a given period of time

a) Cost of storing inventory – involves storage cost, insurance of inventory against fire
and theft, deterioration of inventory due to obsolescence and pilferage

b) Opportunity cost of fund – cost of funds to acquire inventory. If funds would not be
invested in inventory, that would have been invested somewhere else to earn profit

Stock out cost - refers to the capital loss a brand experiences as a result of a stock-out.
Simply put, if a product the customer wants to purchase is unavailable, the business loses a
sale.

The benefits of holding inventory are:

 Preventing Sales Losses

 Securing Quantity Discounts
 Ensuring Production Continuity
 Reducing Ordering Costs
 Preparedness for Contingencies
 Optimal Resource Utilization
Valuation of material issues:

Valuation of materials is useful for two reasons viz. to determine the overall production cost
and valuing stocks or inventory for financial statements. In order to ascertain the cost of
production per product as accurately as possible and to value the closing stock of raw
materials, Work-in – Process and finished products reflecting the true valuation, the pricing
of materials issue should be done based on some accepted principles.

Specific cost price method – Where materials are purchased specifically for a specific job or
order, actual cost of materials is charged to that job. Under the actual cost method, materials
issued are priced at their actual cost involving identification of each purchase.

Actual Cost price method – materials will be used for productive purpose. Organization
purchases and stores repeatedly for regular production and business operations and then
based on requirement by user departments. Four types of methods are there:

 FIFO (First in First out) method - an asset-management and valuation method in

which assets produced or acquired first are sold, used, or disposed of first. FIFO
assumes assets with the oldest costs are included in the income statement's Cost of
Goods Sold (COGS). The oldest stock is issued first at purchase price, then the next
and so on. One issue of stores being composed of more than one price possibly. At the
end of the period, materials in stock are priced at latest purchase price.
 LIFO (Last in First out) method – materials received last are assumed to be issued
first in accounting terms and cost flows, although physical issues may be different.
Materials here are always issued at or near to their current market price i.e. latest
purchase price, but the value of stock remaining in stores is always calculated at
oldest purchase price.
 HIFO (Highest in, first out) method - is a method of accounting for a firm's
inventories wherein the highest cost items are the first to be taken out of stock. HIFO
inventory helps a company decrease their taxable income since it will realize the
highest cost of goods sold.
 Base Stock price Method – The primary goal of the Base Stock Method is to
balance the need for meeting customer demand with managing inventory costs. Under
the Base Stock Method, a company establishes a base stock level for each item in its
inventory, based on factors such as historical sales data, lead times, order quantities,
and desired level of customer service. The company then monitors its inventory levels
 continuously and places new orders to replenish the stock as needed, ensuring that the
base stock level is maintained. It is an inventory management technique used to
determine the appropriate reorder point for a particular item. It involves maintaining a
minimum level of inventory (known as the base stock) at all times, while ordering
additional stock to replenish the inventory as it is consumed.

Average cost price method - based on the assumption that the value of total assets is
equal to the average cost of the total assets.
 Simple average price method
Materials issue price per unit = (total of units prices of each purchase ÷ total number of
purchases)

 Weighted average price method

This is calculated by dividing the total cost of materials in stock and new receipts by
the relative total quantity. The issue price is calculated on receipt of materials and this
is applied until the next lot of materials is received. This method evens out variations
under fluctuating pricing conditions.
 Periodic simple average price method – similar to simple average price method
except that the average price is calculated at the end of the pre - determined and pre-
decided period like month, week etc. and not at the time of each new receipt of
materials.
 Periodic weighted average price method – just like weighted average price method
except that calculations of issue are made periodically, not at the time of new receipt
 Moving simple average price method – the average price is calculated by dividing
the sum total of simple average unit prices of a given period by the number of prices
during the selected period. The average may be based on 3 or 6 months and it goes on
moving by including the month for which average price is calculated and excluding
the first month.
 Moving weighted average price method
MWA = (total amount of the periods ÷ total quantity of periods)
 Notional Price method - these methods are to be used with an intention to know the
estimated or expected cost of manufacturing or acquisition, often in terms of a unit of
product computed on the basis of information available in advance of actual
production or purchase. These are basically prospective costs since they refer to
prediction of costs.
 Standard price method – a standard price is a pre-determined price for a particular
period after considering all factors. A standard price is fixed for each material and
issues are priced at a standard rate. All receipts are recorded at actual prices paid or
payable but all issues are priced at standard rate. Any difference between standard
prices should be modified periodically in the light of changing conditions
 Replacement price method – materials issued are valued at the replacement cost of
the item, i.e. market price on the date when materials are issued. The product cost
under this method is at current market prices which is the main objective.
 Inflated price method – in some cases materials are issued above the cost price. The
inflated price includes the cost of items purchased, contingencies and other related
costs. Above all, certain unavoidable losses arising out of evaporation, leakage and
losses due to loading and unloading of materials have to be recovered. The issue price
of material is inflated to cover up such losses.

The valuation of materials issues brings in light the abnormality in the management of
inventory. These call for establishing proper level of inventory control.

Material Control
Materials need to be controlled because they constitute one of the important current assets
and account for significant portion of total cost in different industries and hence material
control leads to the control of production cost. So ultimately the utility of material control lies
in achieving maximum efficiency in production and sales with least investment in inventory.

Methods of Inventory control:

1. Fixation of inventory levels

a) Reorder level – the level of material stock at which it is necessary to take steps
for further lots of materials.

Reorder level = minimum level + (average rate of consumption × Average lead time)
Or
Reorder level = maximum reorder period × maximum usage
Lead time means the time lag between the dates of issuing material requisition by user
department and receipt of material.
b) Minimum level - the level below which actual stock should not fall
Minimum level = Reorder level – (Avg. Rate of consumption Avg. Lead time)
c) Maximum level - maximum quantity to be held in stock at any time. Reorder
quantity is also known as Economic order Quantity

Maximum level = reorder level + reorder quantity – ( minimum rate of consumption × minimum lead time)

d) Safety stock level – Under the conditions of certainty, reorder point is the avg.
usage required for the lead time. Safety stock is a buffer of inventory held to
protect against stock-outs. Safety stock can be used if demand exceeds a sales
forecast, production output is less than planned, or supply chain disruption results
in long lead times.
In the situation of uncertainties and when safety stock is maintained, reorder point
can be calculated as
Reorder Point = (Lead time × Avg. Usage) + Safety Stock

Because safety stock ties up capital, supply chain managers will try to
minimise the quantity they hold, balancing the risks of running out against
the impacts of over stocking.

It’s important to note that the optimal level of safety stock varies product by
product. That’s because each product will have a different rate of
consumption and lead time – which directly affects how much safety stock is
needed.
e) Danger stock level – This is the level fixed below minimum stock level. If the
stock reaches this level, it indicates the need to take up urgent action in respect of
getting the supply. It is the level of stock below which material should never be
allowed to fall in normal scenarios. It is quite lower level than the minimum stock
level generally.

Danger level = maximum delivery time for emergency purchase× maximum rate of consumption
Or

Danger level= Avg. rate of consumption × lead time for emergency purchases

Or

Danger level= maximum rate of consumption × lead time for emergency purchases

f) Average stock level –

ASL = (Max level + Min Level) ÷ 2

Or
ASL = (opening stock+ closing stock) ÷ 2
Or
ASL = Minimum Level + ½ (Reorder Level)
Or
ASL = Maximum level + ½ (Reorder Level)

Exercise:

From the following information, calculate the level of stores.

Average delivery time 20 days

Minimum delivery time 15 days

Maximum Delivery Time 30 days

Maximum delivery period for emergency purchase 5 days

Average rate of consumption per day 25 units

Maximum rate of consumption per day 35 units

Maximum rate of consumption per day 14 units

Standard ordering quantity 600 units

Economic Order Quantity
EOQ is an optimum quantity of materials to be ordered after consideration of three categories
of costs viz. Ordering cost, Carrying cost and Stock out cost.

Ordering costs are considered expenses related to placing orders for new inventory.
Transportation, shipping fees, inspection fees, and other expenses for conveying the order
come under it. These costs are generally fixed in nature

This cost is also known as the possession cost. These costs vary from item to item and plant
to plant. Carrying costs are the various costs a business pays for holding inventory in stock.
Examples of carrying costs include warehouse storage fees, taxes, insurance, employee costs,
and opportunity costs.

Stock-out costs are both direct and indirect expenses incurred by a business when it runs out
of stock. Left unaddressed, these costs can have a significant impact on a company's margins,
revenue, and profitability. Direct stock-out costs are expenses that are related to the loss of
sales due to stock-out.

EOQ stands for Economic Order Quantity. It is a measurement used in the field of
Operations, Logistics, and Supply Management. In essence, EOQ is a tool used to determine
the volume and frequency of orders required to satisfy a given level of demand while
minimizing the cost per order.

Economic order quantity is a calculation companies use to figure out the optimal number of
inventory units to order, with the goal to minimize the logistics costs, warehousing space,
stock-outs, and overstock costs. The goal of the EOQ model is to determine the ideal quantity
of units for an order that enables you to meet demand without over- or under-stocking.

Exercise:
From the following information, calculate annual usage.
Economic order quantity 300 units
Cost of placing an order Rs. 25
Carrying cost per unit per annum 8 %
Purchase price per unit Rs. 100
_____________________________________________________________________
Exercise:

The annual demand of a certain component bought from the market is 1000 units. The
cost of placing an order is Rs. 60 and the carrying cost per unit is Rs. 3 p.a. Calculate
the Economic Order Quantity for the item.

_____________________________________________________________________
ABC (Always Better Control) analysis or Proportional Parts Value Analysis or Pareto
Analysis

ABC method of inventory control involves a system that controls inventory and is used for
materials and throughout the distribution management. It is also known as selective inventory
control or SIC.

ABC analysis is a method in which inventory is divided into three categories, i.e. A, B, and C
in descending value. The items in the A category have the highest value, B category items are
of lower value than A, and C category items have the lowest value.

Inventory control and management are critical for a business. They help to keep their costs
under control. The ABC analysis helps the business to control inventory by letting the
management focus on the highest value goods (the A-items) and not on the many low-value
goods (the C-items).

ABC Method of Inventory Control

It has become an indispensable part of a business and the ABC analysis is widely used for
unfinished good, manufactured products, spare parts, components, finished items and
assembly items. Under this method, the management divides the items into three categories
A, B and C; where A is the most important item and C the least valuable.

ABC inventory analysis is based on the Pareto Principle. The Pareto Principle states that 80%
of the sales volume are generated from the top 20% of the items. It means that the top 20% of
the items will generate 80% of the revenue for the business. It is also known as the 80/20
rule.

This method is significant to identify the top category of inventory items that generate a high
percentage of yearly consumption. It helps the managers to optimize the inventory levels and
achieve efficient use of stock management resources.

Need for Prioritizing Inventory

Item A:

In the ABC model of inventory control, items categorized under A are goods that register the
highest value in terms of annual consumption. It is interesting to note that the top 70 to 80
percent of the yearly consumption value of the company comes from only about 10 to 20
percent of the total inventory items. Hence, it is crucial to prioritize these items.

Item B:

These are items that have a medium consumption value. These amount to about 30 percent of
the total inventory in a company which accounts for about 15 to 20 percent of annual
consumption value.

Item C:

The items placed in this category have the lowest consumption value and account for less
than 5 percent of the annual consumption value that comes from about 50 percent of the total
inventory items.

Note: The annual consumption value is calculated by the formula: (Annual demand) × (item
cost per unit)

VED analysis

VED analysis is an inventory classification technique that divides items into three
fundamental categories:

Vital (V): These are products that are absolutely crucial for business operations. Without
them, production or sales could come to a halt, significantly impacting profitability and
customer satisfaction.

Essential (E): These items are important but not critical. Their absence could cause
inconveniences and delays but wouldn't completely halt business operations.

Desirable (D): These are products that, while not essential, enhance the customer experience
or business efficiency. Their absence wouldn't significantly impact operations but could
affect reviews and brand perception.

By classifying your products according to their importance, it can be ensured that vital
products are always in stock, preventing operational disruptions. One can optimize inventory
levels for essential products, reducing storage costs.
Perpetual inventory system

A perpetual inventory system is a system used to track and record stock levels, in which
every purchase and sale of stock is logged automatically and immediately. In this system,
every time a transaction takes place, the software records a change in inventory levels in real-
time.

Under the perpetual inventory system, an entity continually updates its inventory records in
real time. To do this, it constantly updates an inventory database to account for received
inventory items, goods sold from stock, items moved from one location to another, items
picked from inventory for use in the production process, and items scrapped.

Inventory Turnover Ratio

Ratio of materials consumed to the average inventory held.

ITR = (Value of Material Consumed during a period) ÷ (Average inventory held during a
period)

Average Inventory = (Opening Stock + Closing Stock) ÷ 2

Inventory Turnover can be indicated in terms of number of days in which average inventory
is consumed. It can be done by dividing 360 or 365 days (A Year) by inventory turnover
ratio.

7. Receivables (Debtors) Management

Receivables, also known as accounts receivables, trade receivables, sundry debtors or
trade debtors are short term assets arising from sale of merchandise or services on
credit. When an organization sells its goods and services on credit, book debts are
created, which are called receivables.
It is important for an organization to get back returns on its receivables preventing
situations of overdue payment or non-payment that ultimately leads to bankruptcy of
the organization. That is why receivable management is important. It is a process of
minimizing risk and maximizing returns on receivables.
 Objectives of receivables management:
1. Avoid transaction disputes and maintain good partnership

2. Optimize investments in receivables

3. Monitor cash flow to minimize bad debts

Optimum Credit Policy:

Optimum Credit policy is one, which maximizes the firm’s value. To achieve this goal the
evaluation of investment in receivables should involve the estimation of incremental
operating profit; investment in receivables; estimation of the rate of return of investment;
comparison of the rate of return with the required rate of return Sales increase by credit
extension is associated with bad debt costs, because of defaulting accounts. Though return on
credit sales increases firm’s returns, simultaneously firm’s liquidity is affected because of
slow recovery of debts and at times no recovery of some of the debts

The analysis of the determination of optimum credit policy involves analysis of opportunity
cost of lost contribution and credit administration costs and bad debt losses. These two costs
behave contrary to each other. As the firm moves from tight to loose credit policy; the
opportunity cost declines, but the credit administration costs and bad-debt-losses increase.
The optimum credit policy lies at a point where these two lines intersect with each other, at
which the costs of credit policy are minimum.
The cost of receivables includes interest on investment in trade debtors, accounting charges in
maintaining their accounts, collection charges and bad debts. The decision should be taken on
the basis of incremental cost and incremental rise in the profitability.

Various dimensions of receivables management

 Credit policy: A credit policy is the foundation of an effective receivables
management system. It establishes the criteria for extending credit to customers,
including credit terms, credit limits, and credit scoring methods. A well-designed
credit policy helps to minimize the risk of non-payment and ensures that customers
pay their bills on time.
 Credit monitoring: Once credit has been extended, it is important to monitor the
creditworthiness of customers on an ongoing basis. This can be achieved through
regular credit reviews, which involve assessing the creditworthiness of customers
based on their payment history, financial statements, and other relevant factors. Credit
monitoring helps to identify potential credit risks before they become a problem.
 Invoicing and billing: Invoicing and billing are critical aspects of receivables
management. Invoicing should be timely and accurate, and it should include all
relevant information, such as the amount owed, the due date, and the payment terms.
Billing should be done on a regular basis, and customers should be notified promptly
of any overdue payments.
 Collection procedures: Collection procedures are the actions taken to collect overdue
accounts receivables. Effective collection procedures include sending reminder
notices, making phone calls, and engaging in collection negotiations. Collection
procedures should be consistent and should be designed to minimize the risk of
customer complaints and legal action.
 Payment processing: Payment processing involves the receipt and processing of
payments from customers. Payment processing should be efficient and accurate, and it
should include procedures for reconciling payments with invoices and applying
payments to the correct accounts.
 Reporting and analysis: Reporting and analysis are important aspects of receivables
management. Reports should be generated on a regular basis to provide management
with information on the status of accounts receivables, including ageing reports,
collection reports, and cash flow reports. Analysis of this information can help to
identify trends and areas for improvement in the receivables management process.

Monitoring receivables
Age wise analysis – period for which various debtors are outstanding. Like 0-30 days, 30-60
days etc. Considering the normal credit period, debtors outstanding for more than that period
should be attempted to be collected on priority basis
Accounts receivables turnover ratio –
Daily credit sales = (Net credit sales per year ÷ 365 days)
Accounts receivables turnover ratio (in days)
= {(accounts receivables+bills receivables) ÷ daily credit sales
Daily sales outstanding (DSO) – If DSO is more than set parameters, organisation should
take adequate steps top speed up collection
DSO = Avg. receivables plus bills receivables / Avg. daily sales
Overdue Receivables ageing schedule – breaking down overdue receivables according to the
length of time for which they have been overdue i.e. number of days passed after the due date

Cost of trade credit – it is the terms that suppliers offer businesses for trade credit. Trade
credit is the amount businesses owe to their suppliers on inventory, products, and other goods
necessary for business operation.
Rate per cent cost of capital (RPCC)
= [{( Interest ÷ Principle) ( 360 ÷ Period of trade credit)} × 100]
IRPC
= [{( interest expense per cent ÷ principle in 100 per cent) ( 360 ÷ period of trade credit)} ×
100]

Exercise:

A firm has annual sales of Rs. 30,00,000. It desires to adopt more liberal credit policies
and for that matter, rise the collection period from 36 days to 60 days. This policy is
estimated to enhance sales by 25 %. The selling price of the product is Rs. 10 per unit,
of which variable cost amounts to Rs. 7. The firm expects 25 % rate of return on
investment. Would you advice the firm to raise its collection period? ( Assume 360 days
in a year).

Exercise:

The sale of goods to the customer to the value of Rs. 2000 on 90 days credit terms with
an average bad debt rate of 3 % and 2 % on administration cost of outstanding balance.
Calculate the cost of credit.

Exercise:
XYZ Ltd. Is selling its products on credit basis and its customers are associated with
5% credit risk. The annual turnover is expected at Rs. 500000 if credit is extended with
cost of sales at 75 % of sales value. The cost of capital of the company is 15 %. Calculate
the net profit of the company.

8. Financing of Working Capital

Working Capital management refers to the management of short term assets i.e.
current assets involving planning and controlling the level and mix of the
organization’s current assets as well as pattern of their financing.
Two issues are importance – optimal level of current assets and how these current
assets to be financed.
The sources to finance current assets can be categorized into long term and short term
sources. Long term sources include shares, debentures, preference shares, retained
earnings, debt from financing institutions and so on. On the other hand short term
sources comprise short term bank loans and commercial papers. Ratio of current
assets to sales and ratio of short-term financing to long-term financing are important
in formulating the policy for financing working capital.
When uncertainty characterises factors on working capital components investment in
current assets cannot be specified uniquely and expenditure on current assets is
limited to meet basic requirements and cope with unusual demands i.e. safety
component. But safety component depends on how conservative and aggressive is the
current asset policy.
 Conservative current asset policy – surplus current assets enable the organisation to
cope easily with variation in sales, production plans and procurement time. Higher
liquidity diminishes the chances of technical insolvency. Reduction of risk
accompanied by lower expected profitability
 Aggressive current asset policy – minimise investment in current assets exposing
greater risk. Organisation may be unable to cope with unanticipated changes. Risk of
technical insolvency is greater. Higher risk is compensated by higher expected
profitability.
 Moderate current asset policy – aims to optimise investment in current asset. Level
of investment in current asset remain at optimum level between maximum and
minimum.
Approaches to working capital financing:

Conservative approach

An organization undertakes this strategy only when it requires minimizing risk to the furthest.
Under this policy, the management regulates the credit limits stringently to ensure low risk.

Moreover, current assets are always above par against the current liabilities to ascertain
sufficient availability of funds.

Organizations majorly utilize long-term funding options to finance fixed and fluctuating
current assets. The use of short-term sources is kept to a minimum for low-risk.

Observing a conservative working capital financing policy, hence, leads to underutilization of

funds, thus cutting down on returns and compromising growth.

Aggressive Policy

As the name may suggest, aggressive policies involve the maximum risk, and thus, also bring
the potential for multiplied growth.

When observing this strategy, companies ensure their current assets, such as the value of
debtors, are minimized by ensuring timely payments or minimum credit sales. At the same
time, management also maintains that payments to creditors are delayed to the furthest.

Organizations aiming at accelerated growth can opt for this working capital policy. However,
since it involves immense risk, strong business acumen, and deft handling of finances are
critical.

Marketing approach

Also known as hedging approach or matching approach. Each asset will be balanced with a
financing instrument of the same appropriate maturity. Type of financing plan involves the
matching of expected life of asset with the expected maturity period of source of funds raised
to finance the assets. Like stock to be sold in 45 days may be financed with a 45day’s bank
loan. Here temporary working capital can be financed with the help of short-term sources and
permanent working capital through long-term sources. Long-term financing will be used to
finance fixed assets and permanent current assets; short term funds to finance temporary or
variable working capital.

Short-term vs. Long-term Financing

Based on analysis of certain factors determining the use of long-term and short-term funds
like flexibility, cost and risk an organization can use either short-term or long-term funds in
order to finance its assets. It should also decide the extent to which a portion of assets under
short-term funds can be used.
Risk-return trade-off

While deciding its working capital financing policy, the organization has to consider two
dimensions – level of current assets and level of short-term funds. Short term financing is less
costly than long term financing, but at the same time short term financing involves greater
risk than long term financing. Thus, there has to be equilibrium between risk and return.

Relative liquidity of financial structure can be measured with the help of the ratio of short
term funds to total funds. Lower this ratio, lesser is risk and lower profitability. Relative
liquidity of asset structure is measured with the help of the ratio between current assets to
fixed or total assets. Greater this ratio, lesser is the risk and lower profit. If the organization
maintains high level of current assets combined with high level of long term funds its
working capital policy is conservative. Here risk will be lower and lesser will be
profitability. If it maintains low level of current asset and low level of long term funds – that
will be aggressive policy (risk and profitability both will be high).

Factoring

Factoring is also known as receivables factoring or invoice financing. A factoring company

buys the invoices or debts of another company. The company that sells its receivables thus
has the advantage that it receives payment immediately, even if the deadline for the
receivable has not yet expired. Factoring can therefore be an effective means of avoiding or
bridging liquidity bottlenecks.

Factoring is offered both by banks and by private companies specialising in it. Factoring
services can be used by companies, self-employed persons as well as individuals.

Factoring is the process of selling these outstanding invoices to a financier or ‘factor’. You
sell the invoice at a discounted rate, lower than the money owed on the invoice. The factoring
firm makes a profit by then chasing up the client to whom the unpaid invoice is addressed
and charging them the full amount.

How Does Factoring Work?

Factoring involves three parties:

 Business/Client Firm
 Factor
 Debtor
The debtor owes money to the business/client firm, which is documented in an invoice. The
debtor is expected to repay the business within a certain period of time.
If the business has short term cash requirements, it can sell this invoice to a factor at a
discounted rate.

The factor purchases the invoice from the business in exchange for cash, which the business
can use immediately, instead of waiting six months for the original invoice to mature.

When the invoice matures in six months, the vendor/debtor will repay the original amount to
the factor and not to the business.

The mechanism of factoring finance can be best understood with an example -

a) Suppose, a business (X) sells goods worth Rs.10,000 to its customers. It sells
these invoices to a factor (Y) because it needs quick money for its transactions.

b) Y will purchase the invoices and deduct 5% of this amount towards its
commission. This rate is decided between both parties and is usually between 3
to 5%.

c) So, Y earns Rs.500 commission from this transaction. On the remaining

amount of Rs.9500, Y may agree to pay 80% immediately and the remaining 20%
after X has received its money from its customers as per the payment cycle.

d) In this case, Y pays X 80% of Rs.9,500, which is Rs.7600 immediately.

Benefits of Factoring as a Source of Funding

Fulfils Young businesses have high overheads and daily operational costs.
Financial Needs Factoring unlocks liquid cash in the short-term with minimal risk.

With factoring, businesses can insulate themselves from the risk of

Reduces Risk defaults and bad debts. These risks are taken on by the factor!

No Collateral Factoring is one of the few funding options where businesses do not need
Funding to provide collateral, making it completely risk-free!

No Credit Unlike bank loans, availing funding through factoring does not require
Checks high creditworthiness or extensive background checks.
Improves Cash Factoring is a great source of cash inflow especially for industries where
Flow receivables take a long time to convert to cash.

Types of Factoring:

Recourse Factoring

In this type of factoring, the factor does not take on the risk of default. If the debtor fails to
repay the invoice, the liability falls on the business firm itself.

Non-Recourse Factoring

The liability of bad debt remains with the factor, and they cannot reclaim the money from the
business in case the debtor defaults.

Advance Factoring

The factor gives the business an advance payment in exchange for the accounts receivable.

Maturity Factoring

The factor makes the payment only on the date of maturity of the invoice. Businesses opt for
this method to insulate themselves from credit risk.

Forfaiting
Forfaiting is a financial process involving the management of finance exports. It aids
businesses by helping them manage their foreign exchange risk. It involves a business selling
its accounts receivable to a financial entity at a discounted rate in exchange for immediate
payment. Forfaiting usually involves medium and long-term receivables and is usually
carried about by financial firms that specialise in the area of export financing.

The exporter sells its claim on medium and long-term trade receivables to a forfaiter at a
discounted rate to receive fast access to cash. The benefit: Exporters minimize the risk of
factoring by selling without recourse, which means the exporter is not liable when the
importer fails to pay the receivables.

How does Forfaiting Work

Forfaiting empowers businesses by allowing them to receive payment for their goods and
services upfront rather than waiting for the importer to pay the invoice. This can be especially
useful for businesses that may not have the financial resources to wait for payment or to
absorb the risk of non-payment.
In this process, the forfaiter will immediately pay the exporter a percentage of the invoice
amount. In return, the exporter transfers the rights to the invoice to the forfaiter. Then the
forfaiter will collect the full invoice amount from the importer.

In the event that the importer does not pay the invoice amount, the exporter is in no way held
accountable. Instead, the forfaiter who has bought the invoices will be responsible for
covering the loss. This practice of assuming the risk by the forfaiter is known as a “non-
recourse” transaction model.

In most cases, the importer’s bank will guarantee the amount to be paid towards the invoice.
The receivables are generally converted to debt instruments. This allows it to be freely traded
on a secondary market and is legally enforceable, thus lending some level of security from
risk to the forfaiting entity.

As a result, a forfaiting transaction acts as a security blanket for businesses by offering them
monetary stability. This, in turn, allows them to focus their energies on critical operational
issues and core business tasks instead of worrying about collecting payments and invoices.

Factoring is typically used to obtain short-term financing, while forfaiting is used to manage
long-term trade receivables. Types of assets: Factoring involves the sale of accounts
receivable, while forfaiting involves the sale of trade receivables, such as promissory notes
and bills of exchange.

The main difference between the two is that factoring can be used in domestic and
international trade, whereas forfaiting only applies to international trade financing.

Factoring: Deals with short-term accounts receivables, which typically falls due within 90
days or less. The sale of receivables are usually on ordinary products or services. Business
owners usually get 80% to 90% financing.

Forfaiting: Deals with medium- to long-term accounts receivables. The sales of receivables
are on capital goods. Funds exporters with 100% financing of the value of exported goods.
Always non-recourse.

If a business has sufficient staff and information systems to manage outstanding invoices
efficiently and then the organization may want to consider an invoice discounting rather than
factoring. It is identical to factoring except that in the sales ledger management, the collection
responsibility remains with the organization and the service is undisclosed to the customer.

Sources of financing working capital:

Long term sources – share capital (equity and preference), retained earnings and debentures
or bonds of different types, loans from bank and financial institutions, venture capital
financing, etc. are long-term sources of financing working capital.

Short term sources – broadly of two categories: bank credit (cash credit, bills finance,
overdraft, loans, and commercial papers) and transaction credit (trade credit allowed by
creditors, outstanding labour and other expenses)

Some of the short term sources:

Trade Credit

Trade credit is a common source of short-term working capital. It involves delaying payment
to suppliers, which effectively provides an interest-free loan for a specific period. While it can
improve cash flow in the short term, businesses should be cautious about straining supplier
relationships.

Advances from customers

Manufacturers and contractors engaged in producing and constructing costly goods involving
considerable length of manufacturing or construction usually demand advance mainly from
their customers at the time of accepting orders for executing contracts or supplying goods

Loans

Entire advance is disbursed at one time either in cash or by transfer to the current account of
the borrower

Bank Overdrafts
A bank overdraft is an excellent short-term financing option that allows businesses to
withdraw more funds than they have in their accounts, up to an agreed limit. It serves as a
flexible source of working capital, helping to bridge cash flow gaps during lean periods.

Bank advances

Bank receive deposits from public for different periods at varying rates of interest. These
funds are invested and lent in such a manner that they may be called back when required.
Lending results in receipt of revenue out of which costs such as interest on deposits,
administrative costs are met and a reasonable profit is made.

Commercial paper

Short term unsecured promissory note issued by organizations with a high credit standing.
Most commercial papers have maturity ranging from seven days to one year and
denomination of minimum Rs. 5 Lakh and multiple thereof.

Cash Credit

Cash credit is an arrangement under which a customer is allowed to draw advance up to a

certain limit against credit granted by a bank. Such limit is sanctioned against the security of
goods through pledge or mortgage or hypothecation. Though these amounts are repayable on
demand, banks usually do not recall. Under this facility, the organization is allowed to
withdraw funds from the bank up to the sanctioned limit. The organization is not required to
borrow entire sanctioned credit at once; rather, the organization can draw periodically to the
extent of requirements and repay it by depositing surplus funds in the organization’s cash
credit account.

Bills purchased and / or discounted

Advances are allowed against the security of bills, which may be clean or documentary. Bills
are sometimes purchased from approved customers in whose favour limits are sanctioned.
The banker evaluates the creditworthiness of the drawer before granting a limit. This facility
enables the organisation to get the immediate payment against the credit bills/ invoices raised
by the organization. The banks holds the bills as a security till the payment is made by the
customer. The entire amount of bill is not paid to the organisation. The organization gets only
the present worth of the amount of the bill, the difference between the face value of the bill
and the amount of assistance being in the form of discount charges. However, on maturity the
bank collects the full amount of bill from the customer.

Advances against documents of title to goods

A document becomes a document of title to goods when its possession is recognised by law
or business custom as possession of goods. These documents include a bill of lading, dock
warehouse keeper’s certificate, railway receipts etc.

Term loan by bank

An instalment credit repayable over a period of time in monthly or quarterly or half yearly or
yearly instalment. Generally term loans are granted by banks for small projects under the
priority sector, small-scale industries and big units.

Public deposits

An organisation having net worth not less than Rs. 100 crores or a turnover not less than Rs.
500 crores can make issuance of public deposits through the means of a special resolution.
The organization can accept public deposits subject to the stipulation of the Reserve Bank of
India and the Ministry of Company Affairs from time to time maximum up to 35 per cent of
its paid up capital and reserves from the public and shareholders. These deposits may be
accepted for a period of six months to five years. Public deposits are unsecured loans and are
used for financing working capital requirements.

What is MPBF?
Maximum Permissible Bank Finance method, also known as MPBF method is a standardized
approach used by banks to determine the maximum amount of working capital financing that
a business can avail from them. It uses operational and financial parameters to calculate the
working capital needs of a company. MPBF is the most common approach to calculating the
working capital needs of a company.
MPBF is mainly a method of working capital assessment. As per the recommendations of
Tandon Committee, the corporate are discouraged from accumulating too much of stocks of
current assets and are recommended to move towards very lean inventories and receivable
levels. This is where MPBF comes into picture. There are 2 methods for MPBF calculation.
Let us see the first one:

MPBF Calculation : (Total Current Assets - Other Current Liabilities) - 25/100*(Total

Current Assets - Other Current Liabilities)

Or MPBF = 75/100*Working Capital Gap

To calculate the working capital gap, you need to subtract current liabilities from current
assets.

Working Capital Gap = Current Assets – Current Liabilities

Depending on the size of credit required, two methods of maximum permissible banking
finance are in practice to fund the working capital needs of the corporate.

MPBF Method I: For corporate whose credit requirement is less than Rs.10 lakhs, banks can
find the working capital required. Working capital is calculated as difference of total current
assets and current liabilities other than bank borrowings (called Maximum Permissible Bank
Finance or MPBF). Banks can finance a maximum of 75 per cent of the required amount and
the rest of the balance has to come out of long-term funds.

MPBF Method II: For corporate with credit requirement of more than Rs.10 lakhs this
method is used. In this method, the borrower finances minimum of 25% of its total current
assets out of long term funds. The rest will be provided by the bank through MPBF. Thus,
total current liabilities inclusive of bank borrowings could not exceed 75% of current assets.

To obtain bank credit for financing working capital requirements, an organisation is required
to make accurate estimation of working capital requirements. For this, organization needs to
estimate the level of current assets and current liabilities as working capital is the difference
between current assets and current liabilities. After deciding the amount of overall assistance
to be extended to the organization, the bank can disburse the amount any of the forms like
fund based lending and non-fund based lending.

In non-fund based lending, the lending bank does not maintain a physical outflow of funds,
thus, the fund position of the bank remains intact. There are two forms of non-fund based
lending:

A bank guarantee is a guarantee given by the bank on behalf of the applicant to cover a
payment obligation to a third party. In other words, the bank becomes a guarantor and
is answerable for the person requesting the guarantee in the event that they are unable to
make the payment they have agreed with a third party. Bank guarantee is mode which will be
found typically in seller’s market.

A bank guarantee is a financial instrument that serves as a promise from a bank to fulfil the
financial obligations of a client, known as the applicant if they fail to meet their commitments
to a third party, referred to as the beneficiary. Essentially, it acts as a safety net, offering
assurance to the beneficiary that they will receive compensation or performance as outlined
in the guarantee terms. This commitment is formalized through a written agreement issued by
the bank, specifying the guarantee’s conditions, terms, and expiration date. Bank guarantees
are versatile and come in various types, including performance, bid, and financial guarantees,
each tailored to specific business needs. The issuing bank evaluates the applicant’s
creditworthiness before providing this commitment, ensuring a level of financial
responsibility. This financial tool is crucial in facilitating international trade, securing
transactions in various industries, and fostering trust between parties engaged in contractual
agreements. Understanding the intricacies of a bank guarantee is essential for businesses
navigating complex financial landscapes and seeking to mitigate risks in their transactions.

Types of Bank Guarantees

Bank guarantees come in various types, each designed to cater to specific needs and
circumstances in the world of finance. Understanding these types is crucial for businesses and
individuals seeking financial instruments tailored to their requirements.

1. Performance Guarantee:
 This type of guarantee assures the beneficiary that the applicant will fulfill their
contractual obligations as specified in the agreement. It’s commonly used in industries
such as construction to ensure that projects are completed as agreed.
2. Bid Guarantee:
 Often required in procurement processes, a bid guarantee assures the project owner
that the bidder will honor their bid and, if awarded the contract, will enter into the
agreement under the proposed terms.
3. Financial Guarantee:
 Assuring financial responsibility: this guarantee is often utilized when the applicant
must demonstrate their ability to meet specific financial commitments, such as lease
agreements or loans.
4. Advance Payment Guarantee:
 In cases where the beneficiary requires an upfront payment, an advance payment
guarantee ensures the return of the advance if the applicant fails to meet the agreed-
upon conditions.
5. Standby Letter of Credit:
 While technically not a bank guarantee, it functions similarly. It acts as a secondary
payment mechanism, ensuring the beneficiary receives payment if the applicant fails
to fulfil their obligations.
6. Payment Guarantee:
 This type of guarantee assures the seller that the buyer will make payment for goods
or services as per the agreed-upon terms, providing a layer of security in commercial
transactions.
7. Retention Money Guarantee:
 Common in construction contracts, this guarantee ensures that the project owner
retains a certain amount of money until the contractor fulfills all contractual
obligations.
8. Immigration Guarantee:
 Often required for visa applications, this guarantee assures immigration authorities
that the individual entering the country will comply with visa regulations and not
become a financial burden.
9. Tender Bond Guarantee:
  Similar to a bid guarantee, this type is specific to tender processes and assures the
project owner that the bidder will enter into the contract if awarded the project.
10. Direct Pay Guarantee:
 Typically used in leasing arrangements, this guarantee ensures that the lessee will
make direct payments to the lessor, mitigating the risk of default.

Bank guarantees and letters of credit both work to reduce risk in a business agreement or
transaction. When a letter of credit or bank guarantee is in place, the parties are more likely to
agree to the transaction.

These agreements are especially important and useful in transactions that would otherwise be
risky, such as certain real estate and international trade contracts.

Clients who are interested in one of these documents are thoroughly screened by banks. A
monetary limit is placed on the agreement after the bank determines that the applicant is
creditworthy and poses a reasonable risk.

 A bank guarantee is a promise made by a lending institution that the bank will step up
if a debtor is unable to repay a debt.

 Letters of credit, which are financial promises made on behalf of one party in a
transaction, are particularly important in international trade.

 Bank guarantees are frequently used in real estate contracts and infrastructure
projects, whereas letters of credit are mostly used in international transactions.

Another significant distinction between bank guarantees and letters of credit is the parties
who use them. Contractors who bid on large projects typically use bank guarantees. The
contractor demonstrates its financial credibility by providing a bank guarantee.

In essence, the guarantee assures the entity behind the project that it is financially stable
enough to take on the project from start to finish. Letters of credit, on the other hand, are
commonly used by businesses that import and export goods on a regular basis.

What is a Letter of Credit?

An LC is a contract by which a bank guarantees the seller that the buyer will make the
payment for the goods and services. The use of LCs to effect payment is widespread in
international trade. This is because they offer security of payment for and receipt of goods to
the parties involved in the trade transaction who may be in different countries.

How Letter of Credit Works

Letter of Credit is issued by the Bank to the Buyer in order to secure the timely payment by
the buyer to the seller. It acts as a guarantee on behalf of the buyer that he/she pays the full
amount to the seller, as per the defined timeline or on time. If in case the buyer is unable to
repay the amount to the seller on time, then the bank will pay on the buyer’s behalf to the
seller.

Parties to a Letter of Credit

Applicant (importer) requests the bank to issue the LC.

Issuing bank (importer’s bank which issues the LC [also known as the Opening banker of
LC]).

Beneficiary (exporter).

Revocable and Irrevocable Credit

A revocable LC is a credit, the terms and conditions of which can be amended/ cancelled by
the Issuing Bank. This cancellation can be done without prior notice to the beneficiaries. An
irrevocable credit is a credit, the terms and conditions of which can neither be amended nor
cancelled. Hence, the opening bank is bound by the commitments given in the LC.

Confirmed/unconfirmed letters of credit

A confirmed letter of credit gives the exporter a double guarantee of payment, one from the
issuing bank and one from the advisory bank. Under a confirmed letter of credit, the advisory
bank agrees to pay the exporter for the goods, even if the issuing bank ultimately fails to
honour its obligations. An unconfirmed letter, in contrast, offers no express guarantee by the
advisory bank. Letters of credit are usually unconfirmed. Confirmed letters are used when an
exporter has doubts about the issuing bank's ability to pay - perhaps because of potential
currency restrictions in the importers' country.

Benefits for Sellers:

1. Guaranteed Payment: One significant advantage for exporters when working with an LC
is that it provides them with assurance regarding payment. The issuing bank becomes
responsible for making payments if the importer fails to meet their obligations.
2. Risk Mitigation: By utilizing an LC, exporters can minimize risks associated with doing
business with unfamiliar partners or countries. This reduces concerns about non-payment or
fraudulent activities.
3. Prompt Payment: With an LC, exporters can expect timely payment once all necessary
documents are presented correctly according to the terms specified in the LC.
4. Improved Cash Flow: Since letters of credit provide greater security compared to other
methods like advance payments or open account terms, exporters can more confidently plan
their finances.

Benefits for Buyers:

1. Delivery Assurance: Importers using an LC ensure that they will receive goods as agreed
upon before making any payments.
2. Reduced Risk: Similar to exporters, importers face less risk by relying on an LC as it
guarantees delivery based on specific conditions outlined within its terms.
3. Flexibility in Payment Terms: Letters of credit allow importers flexibility when
negotiating favorable payment terms aligned with their cash flow requirements.
4. International Credibility: Utilizing letters-of-credit signals credibility and
trustworthiness among global counterparts since these instruments are widely recognized and
accepted across borders.

Fund- based Lending types are usually:

Loan, Overdraft, Cash credit, Bills purchased and discounted, Working Capital Term loans,
Packing Credit

Packing credit is a loan extended to exporters and sellers to meet the expenses of procuring
goods, before shipment. In other words, it is pre-shipment finance that is offered to exporters
and comes in handy for boosting their trade. With the help of packing trade, exporters can
procure raw material or finished products before shipment, and also streamline their export
process seamlessly. In Post- Shipment packing credit, it is to take care of needs of the
organization from the shipment of goods to the overseas buyer till the date of collection of
dues from him. Packing credit may be of the types like: clean packing credit, packing credit
against hypothecation of goods, packing credit against pledge of goods, ECGC (Export Credit
Guarantee Corporation) guarantee, and forward exchange contract.

Security for assistance

The bank may provide assistance in any of the modes discussed so far but normally no
assistance will be available unless the company offers some security in any of the forms like:

Hypothecation - refers to the process of using an asset as collateral for a loan. With
hypothecation, you agree to let that asset be used to secure, or back the loan. But it only
provides backing: You don’t sign any ownership rights over to the lender. You maintain full
possession and use of the asset. The lender has a right to the asset only if you default on the
debt or fail to live up to the loan terms in some other major way.

In short, hypothecation is the way the lender protects itself if the borrower doesn’t repay the
loan or violates the loan agreement.

Mortgage – mode of security pertaining to immovable properties such as land and buildings
indicating the transfer of legal or equitable interest in a specific immovable property as
security for the payment of debt. Possession of the property remains with the borrower while
the bank gets full legal title there to, subject to borrower’s right to repay the debt.

Hypothecation is the pledging of an asset as collateral for a loan, without transferring the
property's title to the lender. In a mortgage, the property purchased is used to secure the loan,
but the lender holds the title.

Pledge - In case of a Pledge, the lender holds on to certain goods or items such as gold, stock
or certificates till the time the borrower makes the complete payment of the loan amount.
Bank extends assistance against security of movable property, usually inventories. If in case
the borrower fails to make the payment on time, the lender can then proceed to sell off those
items kept as security as a means to recover the loan amount. This way, the lender reduces
the risk on its part. Assistance against security of movable property, but unlike hypothecation,
possession of goods is with bank and the goods pledged are in the custody of the bank. In
case of default the bank has the right to sell goods to realise outstanding amount of
assistance. In case of default the bank may; i) sue the borrower for amount due ii) sue for the
sale of goods pledged iii) after due notice, sell the goods

Lien – bank has the right to retain goods belonging to the company until the debt due to the
bank is paid. Particular lien is valid till the claims pertaining to specific goods are fully paid.
General lien is valid till all the dues payable to the bank are paid. Normally banks enjoy
general lien.

RBI scrapped the concept of MPBF and the Indian Bank Association (IBA) group proposed a
new system in order to facilitate need-based working capital without sticking to age- old
policies.

For borrowers with requirements up to Rs. 25 Lakhs, credit limit will be computed after
detailed discussions with the borrower without going into detailed evaluation

For borrowers with requirements above Rs. 25 Lakhs but up to Rs. 5 Crore, credit limit can
be offered up to 20% of the projected gross sales of the borrower.

For large borrowers not selling in the above categories, cash budget system may be used

However, RBI permits banks to follow Tandon and/ or Chore Committee guidelines and
retain MPBF concept with necessary modifications, for deciding the amount of working
capital finance in addition to form of working capital finance and securitisation thereof.

Additional Information:
The Reserve Bank of India had appointed various committees to ensure equitable distribution
of bank resources to various sectors of economy. These committees suggest ways and means
to make the bank credit an effective instrument of industrialization.

Dehejia Committee

A study group under the chairmanship of V.T. Dehejia was constituted in 1968 in order to
determine “the extent to which credit needs of industry and trade were inflated and to suggest
ways and means of curbing this phenomenon”. The committee submitted its reports in
September 1969.
Findings

The important findings of the committee are given below.

1. Higher growth rate of bank credit to industry than the rise in industrial output.

2. Banks in general sanctioned working capital loans to the industry without properly
assessing their needs based on projected financial statements.

3. There was also a tendency on the part of industry to divert short-term bank credit to some
extent for acquiring fixed assets and for other purposes.

4. The present lending system facilitated industrial units to rely on short-term bank credit to
finance for fixed assets.

Recommendations

1. On the basis of the above findings the following recommendations were made by Dehejia
Committee to bring about improvements in the lending system:

2. Credit application should be appraised by the bankers with reference to present and
projected total financial position as shown by cash flow analysis and forecast submitted by
borrowers. The total cash credit requirement is divided into two parts namely (i) Hard core
components representing the minimum level of raw materials, finished goods and stores
which the industry requires for maintaining a given level of production and which is made on
a formal term loan basis. (ii) Short-term components representing the fluctuating part of
current assets.

3. In order to avoid the possibility of multiple financing, a customer should deal with only
one bank. However if the credit requirement is more the committee recommended the
adoption of “Consortium arrangement”.

The recommendations given by Dehejia Committee could not be implemented, further in

view of unprecedented inflation during 1974 the demand for bank credit rose sharply. Most
of the banks had to freeze the credit limit and therefore a need was felt to have a close look at
the entire bank credit system. A Committee was, therefore appointed by RBI in July 1974,
under the chairmanship of Shri P.L.Tandon.
Tandon Committee
 In 1974, a study group under the chairmanship of Mr. P. L. Tandon was constituted for
framing guidelines for commercial banks for follow-up & supervision of bank credit for
ensuring proper end-use of funds. The group submitted its report in August 1975, which came
to be popularly known as Tandon Committee Report on Working Capital. Its main
recommendations related to norms for inventory and receivables, the approach to lending,
style of credit, follow ups & information system.

It was a landmark in the history of bank lending in India. With acceptance of major
recommendations by Reserve Bank of India, a new era of lending began in India.

Tandon committee’s recommendations

Breaking away from traditional methods of security oriented lending, the committee enjoyed
upon the banks to move towards need based lending. The committee pointed out that the best
security of bank loan is a well functioning business enterprise, not the collateral.

Major recommendations of the Tandon committee were as follows:

1. Assessment of need based credit of the borrower on a rational basis on the basis of
their business plans.
2. Bank credit would only be supplementary to the borrower’s resources and not replace them,
i.e. banks would not finance one hundred percent of borrower’s working capital requirement.
3. Bank should ensure proper end use of bank credit by keeping a closer watch on the
borrower’s business, and impose financial discipline on them.
4. Working capital finance would be available to the borrowers on the basis of industry wise
norms (prescribe first by the Tandon Committee and then by Reserve Bank of India) for
holding different current assets, viz.
 Raw materials including stores and others items used in manufacturing process.
 Stock in Process.
 Finished goods.
 Accounts receivables.
5. Credit would be made available to the borrowers in different components like cash
credit; bills purchased and discounted working capital, term loan, etc., depending upon nature
of holding of various current assets.
6. In order to facilitate a close watch under operation of borrowers, bank would require them to
submit at regular intervals, data regarding their business and financial operations, for both the
past and the future periods.

The Norms

Tandon committee had initially suggested norms for holding various current assets for fifteen
different industries. Many of these norms were revised and the least extended to cover almost
all major industries of the country.

The norms for holding different current assets were expressed as follows:
1. Raw materials as so many months’ consumption. They include stores and other items used in
the process of manufacture.
2. Stock-in-process, as so many months’ cost of production.
3. Finished goods and accounts receivable as so many months’ cost of sales and sales
respectively. These figures represent only the average levels. Individual items of finished
goods and receivables could be for different periods which could exceed the indicated norms
so long as the overall average level of finished goods and receivables does not exceed the
amounts as determined in terms of the norm.
4. Stock of spares was not included in the norms. In financial terms, these were considered to be
a small part of total operating expenditure. Banks were expected to assess the requirement of
spares on case-by-case basis. However, they should keep a watchful eye if spares exceed 5%
of total inventories.

The norms were based on average level of holding of a particular current asset, not on the
individual items of a group. For example, if receivables holding norms of an industry was
two months and an unit had satisfied this norm, calculated by dividing annual sales with
average receivables, then the unit would not be asked to delete some of the accounts
receivable, which were being held for more than two months.

The Tandon committee while laying down the norms for holding various current assets made
it very clear that it was against any rigidity and straight jacketing. On one hand, the
committee said that norms were to be regarded as the outer limits for holding different
current assets, but these were not to be considered to be entitlements to hold current assets
upto this level. If a borrower had managed with less in the past, he should continue to do so.
On the other hand, the committee held that allowance must be made for some flexibility
under circumstances justifying a need for re-examination.

The committee itself visualized that there might be deviations of norms in the following
circumstances.

1. Bunched receipt of raw materials including imports.

2. Interruption of production due to power cuts, strikes or other unavoidable circumstances.
3. Transport delays or bottlenecks.
4. Accumulation of finished goods due to non-availability of shipping space for exports or other
disruption in sales.
5. Building up of stocks of finished goods, such as machinery, due to failure on the part of the
purchaser for whom these were specifically designed and manufactured.
6. Need to cover full or substantial requirement of raw materials for specific export contract of
short duration.

While allowing the above exceptions, the committee observed that the deviations should be
for known and specific circumstances and situation, and allowed only for a limited period to
tide over the temporary difficulty of a borrowing unit. Returns to norms would be automatic
when conditions return to normal.

Methods of Lending
The lending framework proposed by Tandon Committee dominated commercial bank
lending in India for more than 20 years and its continues to do so despite withdrawal of
mandatory provision of Reserve Bank of India in 1997.

As indicated before, the essence of Tandon Committee’s recommendations was to finance

only portion of borrowers working capital needs not the whole of it. It was thought that
gradually, the borrower should depend less on banks to fund its working capital needs. From
this point of view the committee three graduated methods of lending, which came to be
known as maximum permissible bank finance system or in short MPBF system.

For the purpose of calculating MPBF of a borrowing unit, all the three methods adopted
equation:

Working Capital Gap = Gross Current Assets — Accounts Payable

…. as a basis which is translated arithmetically as follows:

Gross Current Assets Rs. ………………

Less: Current Liabilities

other than bank borrowings Rs. ……………….

Working Capital Gap Rs. ……………….

First method of lending

The contribution by the borrowing unit is fixed at a minimum of 25% working capital gap
from long-term funds. In order to reduce the reliance of the borrowers on bank borrowings by
bringing in more internal cash generation for the purpose, it would be necessary to raise the
share of the contribution from 25% of the working capital gap to a higher level. The
remaining 75% of the working capital gap would be financed by the bank. This method of
lending gives a current ratio of only 1:1. This is obviously on the low side.

Second method of lending

In order to ensure that the borrowers do enhance their contributions to working capital and to
improve their current ratio, it is necessary to place them under the second method of lending
recommended by the Tandon committee which would give a minimum current ratio of
1.33:1. The borrower will have to provide a minimum of 25% of total current assets from
long-term funds. However, total liabilities inclusive of bank finance would never exceed 75%
of gross current assets. As many of the borrowers may not be immediately in a position to
work under the second method of lending, the excess borrowing should be segregated and
treated as a working capital term loan which should be made repayable in instalments. To
induce the borrowers to repay this loan, it should be charged a higher rate of interest. For the
present, the group recommends that the additional interest may be fixed at 2% per annum
over the rate applicable on the relative cash credit limits. This procedure should be made
compulsory for all borrowers (except sick units) having aggregate working capital limits of
rs.10 lakhs and over.
Third method of lending

Under the third method, permissible bank finance would be calculated in the same manner as
the second method but only after deducting four current assets from the gross current assets.

The borrower’s contribution from long-term funds will be to the extent of the entire core
current assets, as defined, and a minimum of 25% of the balance current assets, thus
strengthening the current ratio further. This method will provide the largest multiplier of bank
finance.

Core portion current assets were presumed to be that permanent level which would generally
vary with the level of the operation of the business. For example, in case of stocks of
materials the core line goes horizontally below the ordering level so that when stocks are
ordered materials are consumed down the ordering level during the lead time and touch the
core level, but are not allowed to go down further. This core level provides a safety cushion
against any sudden shortage of materials in the market or lengthening of delivery time. This
core level is considered to be equivalent to fixed assets and hence, was recommended to be
financed from long-term sources.

Chore Committee

Having implemented the recommendations of the Tandon committee, the RBI constituted
another working group under the chairmanship of Shri K.B. Chore, Chief Officer,
Department of Banking operation and development, RBI.
Chore Committee

Having implemented the recommendations of the Tandon committee, the RBI constituted
another working group under the chairmanship of Shri K.B. Chore, Chief Officer,
Department of Banking operation and development, RBI.

Terms of reference

The committee was asked to review the cash credit system in recent years with particular
reference to the gap between sanctioned limit and the extent of their utilisation.

To suggest alternative types of credit facilities, which should ensure greater credit discipline
and enable the banks to relate credit limits to increase in output or other production activities.
Recommendations

Continuation of existing credit

The existing system of three types of lending namely, cash credits, loans and bills should be
retained.

No bifurcation of credit limit

Bifurcation of cash credit limit into a loan component and a fluctuating cash credit
component has not found acceptance either on the part of the banks or the borrowers.
Therefore the committee recommends withdrawing bifurcation of accounts.

Separate limit for peak and non-peak level requirements

The banks have been asked to fix separate credit limits wherever feasible for the normal non-
peak level and peak level credit requirements and indicate the periods during which the
separate limits would be utilised by the borrowers. If, however, there is no pronounced
seasonal trend, peak-level and normal requirements should be treated as identical and limits
should be fixed on that basis. It should be noted that peak-level and non-peak level concepts
apply not only to agriculture-based industry but also to certain other consumer industries
where the demand may have pronounced seasonal tendencies. Within the limits sanctioned
for the peak-level and non-peak level periods the borrowers should indicate before the
commencement of each quarter the requirements of funds during that quarters. The statement
so submitted by the borrowers should form the basis for quarterly review of the accounts.

Submission of Quarterly Statements

The quarterly statements should be submitted by all the borrowers enjoying working capital
limit of Rs.50 lakhs and above and they will have to bring gradual additional contribution
based on second method of lending as prescribed by the Tandon Committee.

Marathe committee

The RBI, in 1982, appointed a committee under the chairmanship of Marathe to review the
working of credit authorization scheme (CAS) and suggest measure for giving meaningful
direction to the credit management function of the RBI. The RBI with some modifications
has accepted the recommendations of the committee.
Recommendations

The principal recommendations of the Marathe committee include:

1. The committee has declared the third method of lending as suggested by the Tandon
committee to be dropped, hence, in future, the banks would provide credit for working capital
according to the second method of lending.

2. The committee has suggested the introduction of the ‘Fast-Track Scheme’ to improve the
quality of credit appraisal in banks. It recommended that commercial banks can release
without prior approval of the reserve bank 50% of the additional credit required by the
borrowers (75% in case of export oriented manufacturing units) where the following
requirements are fulfilled:

i. The estimate/projections in regard to production, sales, chargeable current asset, current

liabilities other than bank borrowings, and net working capital are reasonable in terms of the
past trends and assumptions regarding most likely trends during the future projected period.

ii. The classification of assets and liabilities as ‘current’ and ‘non-current’ is in conformity
with the guidelines issued by the Reserve Bank of India.

iii. The projected current ratio is not below 1.33:1.

iv. The borrower has been submitting quarterly information and operating statement (form 1,
form 2, and 3) for the past six months within the prescribed time and undertakes to do the
same in future also.

v. The borrower undertakes to submit to the banks his annual account regularly and promptly.
Further, the bank is required to review the borrower’s facilities at least once in a year even if
the borrower does not need enhancement in credit facilities.

Jilani Committee Recommendations.

Background

The Reserve Bank of India has set up a Working group to review the internal control and
inspection and audit system in banks. The working Group which was set up in February 1995
under the chairmanship of Mr Rashid Jilani submitted its reports in July 1995. Jilani
Committee recommendations are divided Into 25 points to be reported to appropriate levels.
The recommendation table is divided into 6 columns as below:-

Recommendation No. in the WG Report

Nature of recommendation

Implementation Status at Branch

Implementation Status at RO/ZO

Implementation status at HO

Objective of Jilani Committee Recommendations:-

Objective of Jilani Committee is to review the efficacy and adequacy of internal control,
inspection and audit system in a bank with a view to strengthening the supervisory system
and reliability of data

There are three categories of recommendations

1. EDP environment in banks

2. Inspection/Internal audit in the banks
3. Miscellaneous aspect of functioning of a bank
Jilani committee recommendations: -

1. Broad guidelines to establish accountability for inspectors/auditors should be laid

down
2. A copy of the booklet incorporating RBI circulars to be supplied to each
inspecting/audit official by inspection and audit department periodically
3. Banks should have system for ratings of its branches on the basis of inspection
reports
4. Major irregularities detected during concurrent audit to be immediately taken up
with Head office
5. Various test to be carried out to ensure that EDP applications have resulted in
consistent and reliable system for inputting, processing and generation of output of
data
6. Entire domain of EDP activities to be brought under scrutiny of inspection and
audit including financial aspect
7. Regular checking by inspectors/auditors to verify correctness of information
complied/furnished by branches

Nayak Committee (1991-92)

The Reserve Bank of India constituted on 9 December 1991, a Committee under the
Chairmanship of Shri P.R. Nayak, Deputy Governor to examine the difficulties confronting
the small scale industries (SSI) in the country in the matter of securing finance.

The terms of reference of the Committee were :

 i. to examine the adequacy of institutional credit for the SSI sector, particularly, with
reference to the increase in the cost of raw materials and locking up of the available
resources due to delay in the realisation of sale proceeds from large companies and
Government agencies,
ii. to examine the adequacy of institutional credit for term finance to the SSI sector,to
examine the need for making any modifications/relaxations in the norms prescribed
by the Tandon/chore Committee in respect of SSI units,
iii. to examine whether any revision is required in the present RBI guidelines for the
rehabilitation of sick SSI units,
iv. in the light of the above, to suggest:
a. suitable arrangements for ensuring adequate flow of institutional credit
for working capital and term finance to the SSI Sector including
refinance arrangements by SIDBI/NABARD etc.,
b. modifications/relaxations, if any, required in the norms prescribed by
the Tandon / Chore Committee in respect of SSI Units.
c. Methods by which the locking up of resources on account of delay in
realisation of bills can be minimised,
d. hanges, if any, required in the present guidelines for rehabilitation of
sick SSI Units and

v. to make recommendations on any other related matter which the Committee may consider
germane to the subject.