Working Capital Management

Working capital refers to be a part of firm’s
capital which is required for financing short
term or current assets such as cash,
marketable securities, debtors and
inventories etc.
It is also known as resolving or circulating
capital or short-term capital.
It refers to the funds, which company must
posses to meet its day to day expenses.
MEANING OF WORKING CAPITAL

In the words of Shubin, “Working capital is
the amount of funds necessary to cost of
operating the expenses”.
According to Genestenberg, “Circulating
capital means current assets of a company
that are changed in the ordinary course of
business from one form to another. For
example, from cash to inventories,
inventories to receivables, receivables into
cash”.
DEFINITION

There are two concepts of working capital:
(A)Balance Sheet Concept
(B)Operating cycle or Circular Flow
Concept
CONCEPTS OF WORKING CAPITAL

(A)Balance Sheet Concept
There are two interpretation of working
capital under the balance sheet concept:
(i) Gross Working Capital
• is the amount invested in total current assets of the
enterprise.
• is the firm’s investment in short term assets such as cash,
short term securities, account receivables and inventories.
• The concept helps in making optimum investment in
current assets and their financing.

(ii)Net working capital
• is the excess of current assets over current
liabilities.
• It can be positive or negative.
• Net working capital = current assets – current
liabilities.
• Net working capital refers to the portion of firm’s
current assets, which financed with long term
funds.

(B) Operating cycle or Circular Flow of concept

CLASSIFICATION OF WORKING CAPITAL
WORKING CAPITAL
BASIS OF
CONCEPT
BASIS OF
TIME
Gross
Working
Capital
Net
Working
Capital
Permanent
/ Fixed
WC
Temporary
/ Variable
WC
Regular
WC
Reserve
WC
Special
WC
Seasonal
WC

Permanent or fixed working capital is
the minimum investment kept in the
form of inventory or raw materials, work
in progress etc to facilitate
uninterrupted operation in the firm.
It also grow with the size of the firm.
It could be financed out of long term
funds.
Permanent working capital

Temporary or Variable working capital is the
amount of working capital which is required to
meet the seasonal demands and some special
exigencies. Variable working capital can be further
classified into Seasonal and Special working
capital.
The capital required to meet the seasonal needs of
the enterprise is called seasonal working capital.
Special working capital is that part of working
capital which is required to meet special situations
such as launching of extensive marketing,
campaign for conducting research etc.
Temporary working capital

Difference between permanent &
temporary working capital
Amount Variable Working Capital
of
Working
Capital
Permanent Working Capital
Time

Variable Working Capital
Amount
of
Working
Capital
Permanent Working Capital
Time
Permanent & Temporary Working Capital

1. Solvency of the firm.
2. Goodwill.
3. Easy Loan.
4. Cash discount.
5. Regular supply of raw materials.
6. Regular payment of salaries, wages and other
day-to-day commitments.
7. Ability to faces crisis
8. High morale.
IMPORTANCE OF ADEQUATE
WORKING CAPITAL

• Excess of working capital represents idle
funds which earn no profits for the business
and hence the business cannot earn a
proper rate of return on its investments.
• Low rate of return
• Unnecessary purchase inventories:
• Defective Credit Policy
• Speculative transaction: His working
capitals in excess give rise to speculative
DANGER OF EXCESS WORKING
CAPITAL

 Loss reputation
 Lowers credit worthless
 Cash Discount
 Irregularity payment of day-to- day
 Low Rate of Return
DANGER OF INADEQUATE
WORKING CAPITAL

1. Nature of the business.
2. Size of the business.
3. Production policy.
4. Production cycle process.
5. Seasonal variation
6. Working capital cycle
FACTORS DETERMINING THE
WORKING CAPITAL REQUIREMENTS

8. Business Cycle
9. Rate of growth of business
10.Price level changes

INTRODUCTION
Definition:
Scientific method of finding out how much
stock should be maintained in order to meet
the production demands and be able to
provide right type of material at right time, in
right quantities and at competitive prices.
06 July 2012 KLE College of Pharmacy, Nipani. 19

Introduction (Cont’d)
• Inventory is actually money, which is available
in the shape of materials (raw materials, in-
process and finished products), equipment,
storage space, work-time etc.
06 July 2012 20
Input
Material
Management
department
Inventory
(money)
Goods in stores
Work-in-progress
Finished products
Equipment etc.
Output
Production
department
Basic inventory model

OBJECTIVES
The specific objectives of inventory
management are as follow:
a) Utilizing of scare resources (capital) and
investment judiciously.
b) Keeping the production on as on-going basis.
c) Preventing idleness of men, machine and
morale.
21

Objectives (Cont’d)
d) Avoiding risk of loss of life (moral & social).
e) Reducing administrative workload.
f) Giving satisfaction to customers in terms of
quality-care, competitive price and prompt
delivery.
g) Inducing confidence in customers and to
create trust and faith.
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Motives for holding inventories
• Transaction motive- to facilitate smooth
production and sales operations.
• Precautionary motive – to guard against the
risk of unpredictable changes in demand and
supply / other forces.
• Speculative motive – influences the decision
to increase or reduce inventory level to take
advantage of price fluctuations.

Why We Want to Hold
Inventories?
• Improve customer service.
• Reduce certain costs such as
– ordering costs
– stock out costs
– acquisition costs
– start-up quality costs
• Contribute to the efficient and effective
operation of the production system.
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TYPES OF DEMAND
• Independent demand
• Dependent demand

Independent Demand Inventory
Systems
• Demand for an item is independent of the
demand for any other item in inventory.
• Finished goods inventory is an example.
• Demands are estimated from forecasts and/or
customer orders.
26

Dependent Demand Inventory
Systems
• Demand of item depends on the demands for
other items.
• For example, the demand for raw materials
and components.
• The systems used to manage these inventories
are different.
27

Independent Demand
A
B C
D E D F
Dependent Demand
Independent demand is uncertain.
Dependent demand is certain.
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Risks and costs associated with
inventories
Risks of holding inventories can be put as
follows:
(i) Price decline
(ii) Product deterioration
(iii) Obsolescence.

Costs of holding inventories
(i) Materials cost – cost of purchasing the goods,
transportation and handling charges, less
discount allowed by the supplier of goods.
(ii) Ordering costs – variable cost associated with
placing an order for the goods.
(iii)Carrying costs – expenses for storing the
goods. It comprises storage costs, insurance
costs, spoilage costs, cost of funds tied up in
inventories etc.

TOOLS AND TECHNIQUES OF
INVENTORY MANAGEMENT
1. ABC Analysis
2. Economic Order Quantity (EOQ)
3. Order Point Problem
(a) minimum level
(b) maximum level
(c) average stock level
(d) reorder level
(e) safety level
4. Two –bin technique

5. VED classification
6.SDE classification
7.Just In Time classification

33
1. ABC Analysis
It is efficient control of stores requires greater in
case of costlier items.

34
Continued….
Item Quality Quantity order Checking
A Costlier Less Regular system to see
that there is no
overstocking as well as
that there is no danger
of production being
interrupted for
unwanted material.
B Less costlier Order may be on
review basis.
Position being viewed
in each month
C Economical Larger Order in large quantity
so that cost can be
avoided

2. EOQ
What is EOQ?
35
EOQ = mathematical device for arriving at
the purchase quantity of an item that
will minimize the cost.
total cost = holding costs + ordering costs

EOQ (Cont’d)
So…What does that mean?
36
Basically, EOQ helps you identify the most
economical way to replenish your inventory
by showing you the best order quantity.

Assumptions of the EOQ Model
1. Demand is known and constant
2. Lead time is known and constant
3. Receipt of inventory is instantaneous
4. Quantity discounts are not available
5. Variable costs are limited to: ordering cost
and carrying (or holding) cost
6. If orders are placed at the right time,
stockouts can be avoided

Ordering cost may be referred to as the “cost of
acquiring while the carrying cost as the “cost of
holding” inventory.
EOQ formula-
Q = Economic order quantity
A = Annual demand in units
O = Ordering cost per unit
C = Carrying cost per unit
Q = 2AO
C

EOQ – GRAPHICAL APPROACH
Ordering Cost
Order Size QEOQ
Minimum Total Costs

40
Maximum stock level
• Quantity of inventory above which should not
be allowed to be kept. This quantity is fixed
keeping in view the disadvantages of
overstocking;
Factors to be considered:
• Amount of capital available.
• Godown space available.
• Possibility of loss.

41
Continue….
• Cost of maintaining stores;
• Likely fluctuation in prices;
• Seasonal nature of supply of material;
• Restriction imposed by Govt.;
• Possibility of change in fashion and habit.

42
Minimum stock level
• This represents the quantity below which
stocks should not be allowed to fall .
• The level is fixed for all items of stores and the
following factors are taken into account:
1.Lead time-
2. Rate of consumption of the material during
the lead time.

43
Re-ordering level
• It is the point at which if stock of the material
in store approaches, the store keeper should
initiate the purchase requisition for fresh
supply of material.
• This level is fixed some where between
maximum and minimum level.

Safety Stock
• Safety stock (SS) is extra inventory held to
help prevent stockouts
• Frequently demand is subject to random
variability (uncertainty)
• If demand is unusually high during lead time,
a stockout will occur if there is no safety stock

4. Two - bin system of inventory
control-suited for small firms:
• Under this system the company maintains
two bins.
• Once the inventory contained in the first bin
gets exhausted, stock is ordered while
inventory in the second bin becomes available
for consumption/sale

5. V-E-D Classification (Cont’d)
• V-Vital : Items without which the
activities will come to a halt.
• E-Essential : Items which are likely to
cause disruption of the
normal activity.
• D-Desirable : In the absence of which the
hospital work does not get
hampered.
46

6. S-D-E Classification
• Based on the lead-time analysis and
availability.
S – Scarce : longer lead time
D – Difficult : long lead time
E – Easy : reasonable lead time

7. Just In Time(JIT) Inventory System
• JIT inventory system means all inventories-raw
materials- work in progress- and finished goods
are received in time.
• Raw materials are received just in time to go into
production
• Manufactured parts are completed just in time to
be assembled into products.
• Products are completed just in time to be shipped
to customers.
The flow of goods is controlled by a “pull approach”.

Benefits of JIT System
• Inventories of all types can be reduced
significantly. His results in saving of costs.
• Storage space used for inventories can be
made available for more productive uses.
• Total Quality Control results in production of
quality products.
• It helps to increase the productivity of
workers.

• Cash management is one of the key areas
of working capital management as cash is
both beginning and the end of working
capital cycle- cash, inventories, receivables
and cash.
• It is the most liquid asset and the basic
input required to keep the business
running on a continuous basis.

Nature of cash
In cash management the term cash has been used in two
senses:
• Narrow sense
Under this cash covers currency and generally accepted
equivalents of cash,cheques,demand drafts and demand
deposits.
• Broad sense
Cash includes not only the above stated but also cash
assets.

Motives of holding cash
• Transaction Motive
This motive arises due to the necessity of having cash for various
disbursements like purchase of raw materials, payment of business
expenses, payment of tax, payment of dividend etc..
• Precautionary Motive
Firm may require cash for payment of unexpected disbursements like
flood, strikes, increase in cost of raw materials etc..
• Speculative Motive
Holding cash relates for investing in profitable opportunities as and
when they arise.

Objectives of Cash Management
• To meet cash payment needs.
The primary objective of cash management is
to meet various cash payment needed to pay in
business operations. The payment are like
payment to supplier of raw materials ,payment
of wages and salary etc..
• To maintain minimum cash balance
Firm should not maintain excess cash balance.

Phases of cash management
1.Cash planning
2.Cash flows management
3.Determination of optimum cash balance
4.Investment of surplus cash

1.Cash Planning
• Cash planning is required to estimate the
cash surplus or deficit for each planning
period. Estimation of cash surplus can be
arrived by preparation of cash budget.
• Cash budget is an important tool for the flow
of cash in any firm over a future period of
time.

2. Cash Flow Management
• Cash flow means cash inflows and outflows. The cash
flows should be properly managed that the cash
inflows should be accelerated.(collected as early as
possible) and cash outflows should be
decelerated(cash payments should be delayed without
affecting firm name).
• Accelerating cash collection
1. Prompt Payment of customers
2. Early conversion of payment into cash
3.Concentration Banking
4. Lock box system

• Slowing down cash payments
1.Paying on last date.
2.Centralised payment

3.Determination of optimum cash balance
• Optimum cash balance is that balance at
which the cost of excess cash and danger
of cash deficiency will match.
• Firms have to determine the optimum
cash balance.
• The most important models are:
1.Baumol model
2.Miller and Orr Model

1.Baumol Model
• This model was developed by William J. Baumol.
• According to this model optimum cash level is that level
of cash where the carrying costs and transaction costs
are the minimum

William J. Baumol's Model
Total Cost
Opportunity Cost
Transaction Cost
Optimum Cash Balance
(Baumol’s Model : Tradeoff Between Holding cost and transaction cost)
Cost

The formula for determining Optimum cash
balance can be put as follows:
____
Where C= √ 2 cT
K
C = Optimum cash balance
c = Average fixed cost of securing cash
(transaction cost)
T = Total cash needed during the year.
K =opportunity cost of holding cash balance

Assumptions
• Cash needs of the firm is known with
certainty
• Cash Disbursement over a period of time is
known with certainty
• Opportunity cost of holding cash is known
and remains constant
• Transaction cost of converting securities
into cash is known and remains constant

Evaluation of the model
• Helpful in determining optimum level of Cash
holding
• Facilitates the finance manager to minimize
Carrying cost and Maintain Cash
• Indicates idle cash Balance Gainful employment
• Applicable only in a situation of certainty in
other words this model is deterministic model

2.Miller and Orr Model
• This model was developed by M. H. Miller and Daniel
Orr
• The Miller and Orr model of cash management is one of
the various cash management models in operation. It is
an important cash management model as well. It helps
the present day companies to manage their cash while
taking into consideration the fluctuations in daily cash
flow.
• As per the Miller and Orr model of cash management the
companies let their cash balance move within two limits
a) Upper Control limit
b) Lower Control Limit

M. H. Miller and Daniel Orr’s Stochastic
Model
Upper Control Limit : Buy Security
Curve representing Cash
Balance
Purchase Market Security
Sale of market
security
Return
Point
Lower Control Limit : Buy Security
Cash
h
Z
O

Computation of Miller – Orr Model of Cash
Management
Z = (3/4 * Transaction cost *Variance of Cash Flow)
Z = (3/4*c /i)
Upper limit =lower limit +3 Z
Return point = lower limit + Z
Average cash balance = lower limit + 4/3 Z
1/3
Interest per day
2 1/3

Evaluation
• The stochastic model can be employed
even in extreme uncertain situation.
• But when the cash flows fluctuate
violently in short period , it will not give
optimal results.
• It is advisable to the finance manager to
apply this model in highly unpredictable
situation.

4.Investment of surplus fund
• Whenever there is surplus cash it should be
properly invested in marketable securities to
earn profits.
• Firms should not invest in long term securities
they cannot be converted into cash within a
short period

MANAGEMENT OF RECEIVABLES
• Management of accounts receivables may be
defined as the process of making decisions
relating to the investment of funds in this
asset which will result in the maximizing the
overall return on the investment of the firm.
• Receivables management is also referred to as
Trade Credit management.

RECEIVABLES
 What are receivables?
• Receivables are sales made on credit basis.
 Why do we need receivables?
• Achieving growth in sales potential
• Increasing profits
• Meeting competition
 Understanding Receivables
• As a part of the operating cycle
• Time lag b/w sales and receivables creates need for working capital

Types of Costs Associated with
Receivables Management
 COLLECTION COST:
Administrative costs incurred in collecting the accounts
receivable.
 CAPITAL COST:
Cost incurred for arranging additional funds to support credit
sales.
 DELINQUENCY COST:
Cost which arises if customers fail to meet their obligations.
 DEFAULT COST:
Amounts which have to written off as bad debts.

Factors affecting the size of receivables
• Level of sales
• Credit Policies
• Terms of trade
• Credit period
• Cash discount

Receivables Management Policies
These policies relate to:
(i) Credit standards
(ii) Credit terms
(iii) Collection procedures

CREDIT STANDARDS
• The term credit standards represent the basic
criteria for extension of credit to customers.
• The levels of sales and receivables are likely to
be high ,if the credit standards are relatively
loose.
• The firm’s credit standards are generally
determined by the five C’s – character,
capacity, capital , collateral and conditions.

“Five Cs” of Credit Analysis
The “Five Cs” of credit analysis used to decide whether or
not to extend credit to a particular customer are :
1. Character: moral integrity of credit applicant and
whether borrower is likely to give his/her best efforts to
honoring credit obligation
2. Capacity: whether borrowing form has financial capacity
to meet required account payments
3. Capital: general financial condition of firm as judged by
analysis of financial statements
4. Collateral: existence of assets (i.e. inventory, accounts
receivable) that may be pledged by borrowing firm as
security for credit extended
5. Conditions: operating and financial condition of firm

CREDIT TERMS
It refers to the terms under which a firm sells
goods on credit to its customers. The two
components of credit terms are:
(a) Credit period
(b) Cash discount

(a) Credit Period
• Credit Terms – Specify the length of time over which credit
is extended to a customer and the discount, if any, given for
early payment. For example, “2/10, net 30.”
• Credit Period – The total length of time over which credit is
extended to a customer to pay a bill. For example, “net 30”
requires full payment to the firm within 30 days from the
invoice date.

Optimal Credit Period
Extending credit period stimulates sales but
increases the cost on account of more tying up of funds
in receivables.
Shortening the credit period reduces the profit on
account of reduced sales, but also reduces the cost of
tying up of funds in receivables.
Determining the optimal credit period, therefore
involves locating the period where the marginal profits
on increased sales are exactly offset by the cost of
carrying the higher amount of accounts receivable.

(b) Cash Discount
Attractive cash discount terms reduce the
average collection period resulting in reduced
investment in accounts receivable.
Optimal discount is established at that
point where the cost and benefit are exactly
offsetting.

Cash Discount Period
• Cash Discount Period – The period of time during
which a cash discount can be taken for early
payment. For example, “2/10” allows a cash discount
in the first 10 days from the invoice date.
Cash Discount – A percent (%) reduction in sales or
purchase price allowed for early payment of invoices.
For example, “2/10” allows the customer to take a 2%
cash discount during the cash discount period.

Types of Policies
• Liberal credit policy :
 Profitability increases on account of higher
sales
Increased investment in receivables
Increased chances of debts
 More collection costs
Total investment in receivables increases and
thus the problem of liquidity is created

(contd…..)
• Stringent credit policy :
Reduces the profitability but increases the
liquidity of the firm.
Optimum credit policy occurs at a point
where there is a trade off between liquidity
and profitability.

Optimum size of receivables
Profitability
Liquidity
Tight Credit
policy
Loose
Costs & Benefits

Collection Procedures
• Letters
• Phone calls
• Personal visits
• Legal action
The firm should increase collection expenditures
until the marginal reduction in bad-debt losses
equals the marginal outlay to collect.

Monitoring Receivables
• 1. Use of Ratios
• DAILY SALES OUTSTANDING (DSO)
DSO = Accounts Receivable
Avg. Daily Sales
• AGEING SCHEDULE
Classifies the outstanding accounts receivables at a given point of time
into different age brackets. Ex.
Age Group (days) % of receivables
0-30 30
31-60 40
61-90 25
>=90 5

Control of receivables Management
• ABC Analysis of Receivables
A – Represents a small proportion of accounts
of debtors representing a large value
B – Represents moderate value
C – Represents a large number of accounts of
debtors but representing a small amount

Working capital is the fund invested in current
assets and is needed for meeting day to day
expenses .
It is an operating liquidity available to a
business.
Along with fixed assets such as plant and
equipment, working capital is considered a
part of operating capital.

The working capital requirements of a firm is
classified into 2
a) Permanent or long term or fixed
working capital requirement
b) Temporary or variable or short term
working capital requirement

Fixed working capital
• Fixed working capital is that portion of the total
capital that is required to be maintained in the
business on the permanent basis or uninterrupted
basis. This working capital is required to invest in
fixed assets. The requirement of this type of working
capital is unaffected due to the changes in the level
of activity.

Variable working capital
• Variable working capital is that portion of the total
capital that is required over and above the fixed
working capital. This working capital is required to
meet the seasonal needs and some contingencies.
The requirement of this type of working capital
changes with the changes in the level of activity.

Sources of working capital
Permanent or fixed Temporary or variable
1.Shares 1.commercial banks
2. Debentures 2.indigeneous bankers
3.Public deposits 3.trade creditors
4.retained profits 4.instalment creditors
5.Loans from financial 5.advances
institutions 6.accrued expences
7. commercial paper
8. commercial banks

CURRENT LIABILITIES
MANAGEMENT

Spontaneous Liabilities
1. Spontaneous liabilities arise from the normal
course of business.
2. The two major sources of spontaneous
liabilities are accounts payable and accruals.
3. As a firm’s sales increases, accounts payable
and accruals increases in response to the
increased purchases, wages, and taxes.
4. There is normally no explicit cost attached to
either of these current liabilities.

Management of Accounts Payable
• Accounts payable are the major source of unsecured
short-term financing for business firms.
The underlying objective of accounts payable is to
slow down payments process as much possible as
possible.
• The delay in accounts payable may result in saving
of some interest costs but it may result in loss of
credit in the market.

Average payment period
• The average payment period has two parts:
– The time from the purchase of raw materials
until the firm mails the payment.
– Payment float time (the time it takes after the
firm mails its payment until the supplier has
withdrawn funds from the firm’s account.
• The finance manager has, therefore, to ensure that
payments to the creditors are made at the stipulated
time periods after obtaining the best credit terms
possible.

Spontaneous Liabilities- Analyzing
Credit Terms
A. Credit terms offered by suppliers allow a firm
to delay payment for its purchases.
B. However, the supplier probably imputes the
cost of offering terms in its selling price.
C. Therefore, the firm should analyze credit
terms to determine its best credit strategy.
D. If a cash discount is offered, the firm has two
options—to take the cash discount or to give
it up.

Analyzing credit terms (contd…..)
• Taking the Cash Discount
– If a firm intends to take a cash discount, it should
pay on the last day of the discount period.
– There is no cost associated with taking a cash
discount
• Giving Up the Cash Discount
– If a firm chooses to give up the cash discount, it
should pay on the final day of the credit period.
– The cost of giving up a cash discount is the
implied rate of interest paid to delay payment of
an account payable for an additional number of
days.

Spontaneous Liabilities: Effects of
Stretching Accounts Payable
• Stretching accounts payable simply involves
paying bills as late as possible without
damaging credit rating.
• This can reduce the cost of giving up the
discount.

Spontaneous Liabilities- Accruals
• Accruals are liabilities for services received for
which payment has yet to be made.
• The most common items accrued by a firm are
wages and taxes.
• While payments to the government cannot be
manipulated, payments to employees can.
• This is accomplished by delaying payment of
wages, or stretching the payment of wages for
as long as possible

Unsecured Sources of Short-Term
Loans: Bank Loans
• The major type of loan made by banks to businesses is
the short-term, self-liquidating loan which are
intended to carry firms through seasonal peaks in
financing needs.
• These loans are generally obtained as companies build
up inventory and experience growth in accounts
receivable.
• As receivables and inventories are converted into cash,
the loans are then retired.
• These loans come in three basic forms:(i) single-
payment notes, (ii) lines of credit, and (iii) revolving
credit agreements.

(i) Single Payment Notes
– A single-payment note is a short-term, one-time
loan payable as a single amount at its maturity.
– The “note” states the terms of the loan, which
include the length of the loan as well as the
interest rate.
– The maturity period of most of these loans vary
from 30 days to 9 or more months.
– The interest may be either fixed or floating.

(ii)Line of Credit (LOC)
– A Line of Credit is an agreement between a
commercial bank and a business specifying the
amount of unsecured short-term borrowing the
bank will make available to the firm over a given
period of time.
– It is usually made for a period of 1 year and often
places various constraints on borrowers.
– Although not guaranteed, the amount of a LOC is
the maximum amount the firm can owe the bank at
any point in time.

In order to obtain the LOC, the borrower may be required to
submit a number of documents including a cash budget, and
recent (and pro forma) financial statements.
The interest rate on a LOC is normally floating .
In addition, banks may impose operating restrictions giving it
the right to revoke the LOC if the firm’s financial condition
changes.
Both LOCs and revolving credit agreements often require
the borrower to maintain compensating balances.
A compensating balance is simply a certain checking account
balance equal to a certain percentage of the amount borrowed
(typically 10 to 20 percent).
This requirement effectively increases the cost of the loan to
the borrower.

(iii)Revolving Credit Agreement (RCA)
– RCA is nothing more than a guaranteed line
of credit.
– Because the bank guarantees the funds will be
available, they usually charge a commitment fee
which applies to the unused portion of the
borrowers credit line.
– A fee is around 0.5% of the average unused
portion of the funds.
– Although more expensive than the LOC, the RCA
is less risky from the borrowers perspective.

• Money Market is the part of financial market where instruments
with high liquidity and very short-term maturities are traded. It's the
place where large financial institutions, dealers and government
participate and meet out their short-term cash needs. They usually
borrow and lend money with the help of instruments or securities to
generate liquidity. Due to highly liquid nature of securities and their
short-term maturities, money market is treated as safe place.
• Role of Reserve Bank of India: The Reserve Bank of India (RBI)
plays a key role of regulator and controller of money market. The
intervention of RBI is varied – curbing crisis situations by reducing
key policy rates or curbing inflationary situations by rising key
policy rates such as Repo, Reverse Repo, CRR etc.

Money Market Instruments
Money Market Instruments provide the
tools by which one can operate in the money
market. Money market instrument meets
short term requirements of the borrowers
and provides liquidity to the lenders. The
most common money market instruments
are Treasury Bills, Certificate of Deposits,
Commercial Papers, Repurchase
Agreements and Banker's
Acceptance,Money Market Mutual Funds.

Instrument of Money Market
• A variety of instrument are available in a
developed money market
• In India till 1986, only a few instrument were
available
Treasury
bills
Commercial
Bills
Money at
call
Promissory
notes

Money Market Instruments
Money
Market
Commercial
Papers
Certificate
of deposit
Repo
instrument
Repurchase
Agreement
Banker's
Acceptance
Mutual
Fund

Commercial paper (CP)
It is a short term unsecured loan issued by a
corporation typically financing day to day
operation
 It is very safe investment because the
financial situation of a company can easily
be predicted over a few months
 Only company with high credit rating issues
CPs

Treasury Bills (T-Bills)
 (T-bills) are the most marketable money market
security
 They are issued with three-month, six-month
and one-year maturities
 T-bills are purchased for a price that is less than
their par(face) value; when they mature, the
government pays the holder the full par value
 T-Bills are so popular among money market
instruments because of affordability to the
individual investors

Certificate of deposit (CD)
 A CD is a time deposit with a bank
 Like most time deposit, funds can not withdrawn
before maturity without paying a penalty
 CDs have specific maturity date, interest rate and it
can be issued in any denomination
 The main advantage of CD is their safety
 Anyone can earn more than a saving account
interest

Repurchase agreement (Repos)
 Repo is a form of overnight borrowing and is used
by those who deal in government securities
 They are usually very short term repurchases
agreement, from overnight to 30 days of more
 The short term maturity and government backing
usually mean that Repos provide lenders with
extremely low risk
 Repos are safe collateral for loans

Banker's Acceptance
 A banker’s acceptance (BA) is a short-term credit
investment created by a non-financial firm
 BAs are guaranteed by a bank to make payment
 Acceptances are traded at discounts from face
value in the secondary market
 BA acts as a negotiable time draft for financing
imports, exports or other transactions in goods
 This is especially useful when the credit worthiness of
a foreign trade partner is unknown

Mutual Funds
• A money market fund (also known as money
market mutual fund) is an open-
ended mutual fund that invests in short-term
debt securities such as US Treasury
bills and commercial paper. Money market
funds are widely (though not necessarily
accurately) regarded as being as safe as bank
deposits yet providing a higher yield. Regulated
in the US under the Investment Company Act of
1940, money market funds are important
providers of liquidity to financial
intermediaries.

WORKING CAPITAL FINANCING
BY BANKS

One of the most important functions of banks
is to finance working capital requirement of firms.
Working capital advances forms major part of advance
portfolio of banks. In determining working capital
requirements of a firm, the bank takes into account its
sales and production plans and desirable level of
current assets. The amount approved by the bank for
the firm’s working capital requirement is called credit
limit . Thus, it is maximum fund which a firm can
obtain from the bank.

CREDIT INSTRUMENTS OF
COMMERCIAL BANKS

• Cash Credit – Under this facility, the bank specifies
apredetermined limit and the borrower is allowed to
withdraw funds from the bank up to that sanctioned credit
limit against a bond or other security.
• Overdraft – Under this arrangement, the borrower is
allowed to withdraw funds in excess of the actual credit
balance in his current account up to a certain specified limit
during a stipulated period against a security.
•Loans – Under this system, the total amount of borrowing is
credited to the current account of the borrower or released to
him in cash. The borrower has to pay interest on the total
amount of loan, irrespective of how much he draws.

• Bills Financing – This facility enables a borrower to
obtain credit from a bank against its bills. The bank
purchases or discounts the bills of exchange and promisory
notes of the borrower and credits the amount in his
account after deducting discount.
• Letter of Credit – While the other forms of credit are
direct forms of financing in which the banks provide funds
as well as bears the risk, letter of credit is an indirect form
of working capital financing in which banks assumes
only the risk and the supplier himself provide the funds.

•Working Capital Loan – Sometimes a borrower may
require additional credit in excess of sanctioned credit limit to
meet unforeseen contingencies. Banks provide such credit
through a Working Capital Demand Loan (WCDL) account or a
separate ‘non–operable’ cash credit account. This arrangement
is presently applicable to borrowers having working capital
requirement of Rs.10 crores or above.

SECURITY REQUIRED IN BANK FINANCE

•Hypothecation – Under this mode of security, the banks
provide working capital finance to the borrower against the
security of movable property, generally inventories. It is a
charge against property for the amount of debt where neither
ownership nor possession is passed to the creditor. In the case
of default the bank has the legal right to sell the property to
realise the amount of debt.
• Pledge – A pledge is bailment of goods as security for the
repayment of a debt or fulfillment of a promise. Under this
mode, the possession of goods offered as security passes into
the hands of the bank

•Lien – Lien means right of the lender to retain property
belonging to the borrower until he repays the debt
•Mortgage – Mortgage is the transfer of a legal or equitable
interest in a specific immovable property for the payment of
a debt.
•Charge – Where immovable property of one person is
made security for the payment of money to another and the
transaction does not amount to mortgage, the latter person is
said to have a charge on the property and all the provisions
of simple mortgage will apply to such a charge.

Working Capital Management

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