1. CONCEPT OF LIQUIDITY

Liquidity is the ability to raise funds easily by selling assets (Hornby 1974).  It is a measure of how easily an asset can be turned into cash. Generally, liquid assets are measured by deducting the value of inventory from current assets. An increase in cash assets enhances liquidity and reduces liquidity risk, which in turn affects the level of profitability. Therefore, liquidity management involves a trade-off between risk and return. It involves forecasting a company's cash needs and providing for these needs in the most cost-effective way (Pandey 1986, pp.336-37). In a nutshell, liquidity management is the management of risk and return of investments.

For banks, liquidity management involves the estimation of the demand for funds by the public and the provision of sufficient reserves to meet these needs. It is the function of liquidity management to estimate the size of demand for funds and fulfill the demand in a manner consistent with the maximization of shareholder's wealth. A bank always must be in a position to fulfill the demands of its depositors. Hence it requires holding in reserve that amount of cash necessary to satisfy the demands of depositors. If a bank does not maintain sufficient liquid assets to meet such demand requirements, it is likely to have liquidity problems.  Failure to maintain the necessary liquidity could lead to the banks ultimate failure.  So maintenance of comparatively small percentage of liquid assets is not favorable to running a bank successfully. With this end in view, Bank Company Act-1991 provides the provision for maintenance of liquid assets for each bank in Sections No. 25 and 33. Accordingly, banks are required to monitor liquidity in two ways: (a) Cash Reserve Ratio and (b) Supplementary Reserve Ratio. When combined, these are known as Statutory Liquidity Requirement.

2. TYPES OF LIQUIDITY

Short Term Liquidity: The fundamental objective in managing a legal reserve position is to meet the minimum requirement at the lowest cost. Because vault cash needs are determined by customer preferences, they vary largely with the payments patterns of the bank's customers and local businesses. They also exhibit well-defined seasonal patterns that are easily forecasted. When a bank needs additional vault cash, it simply requests a cash delivery from its Central Bank or a correspondent bank. It similarly ships any excess cash when appropriate.

Long-term Liquidity: The long-term liquidity planning involves projecting funds needs over the coming year and beyond if necessary. Projections can be separated into four categories viz., base trend, short-term, seasonal, and cyclical values. The analysis may assess a bank's liquidity gap, measured as the difference between potential uses of funds and anticipated sources of funds, over monthly intervals. 

3. LIQUIDITY VS. PROFITABILITY

Liquidity is of vital importance to the daily operations of a bank. Maintenance of a sound liquidity position of the bank is necessary to protect the bank against uncertainties of its business. But the pertinent question is that how much liquidity should be maintained to ensure the profitability of the bank?  In other words, if the bank maintains a small deposit balance, its liquidity position becomes weak and suffers from a paucity of cash to make payments. On the other hand, investing released funds in some profitable opportunities can attain a higher profitability. When the bank does not have an adequate deposit reserve to cover liquidity needs it may have to sell its marketable securities to raise the necessary liquidity.  On the other hand, if the bank maintains a high level of deposit reserves, it will have a sound liquidity position, but forego the opportunities to earn profit through investment. The potential profitability lost on holding large deposit involves an opportunity cost to the bank. Thus, the bank should maintain an optimum level of deposit balances, i.e., neither too small nor too large of a deposit reserve balance.

It appears that maintenance of liquidity bears both risk and return. A trade off between these two elements can minimize the conflict between liquidity versus profitability of a bank. Koch (Ibid, pp.485-86) believed that there is a short-run trade off between liquidity and profitability. The more liquid a bank is, the lower are its return on equity and return on assets, all other things being equal. Both asset and liability liquidity contribute to this relationship. The composition and maturity of funds influence asset liquidity. Large holdings of cash assets clearly decrease profits because of the opportunity cost of forgone investment income. In terms of the investment portfolio, short-term securities normally carry lower yields than comparable longer-term securities. Banks that purchase short-terms securities thus increase liquidity, but at the expense of higher potential return.

He also argued that a traditional bank's loan portfolio displays the same trade-off. Loans carrying the highest yields are the least liquid. Yields are high because default risk or interest rate risk is substantial and the investment administration expense is high.  Loans that can readily be sold usually are short-term credits to well-know corporations or government-guaranteed instruments and thus carry minimal spreads. Amortized loans in contrast, may provide liquidity even though they are frequently long term because the periodic payments increase near-term cash flow.

Further the author described that in terms of liability liquidity, banks with the best asset quality and highest equity capital have greater access to purchased funds. They also pay lower interest rates and generally report lower returns in the short run. Promised yields on loans and securities increase with the perceived default risk of the underlying issuer. Banks that acquire low-default risk assets, such as US government securities, forego the risk premium that could be earned. Interestingly, many banks buy US agency securities because the incremental yield more than compensates for perceived differences in default risk relative to US treasuries. Similarly, banks with greater equity financing exhibit lower equity multipliers and thus generate lower returns on equity, even with identical returns on assets. These banks can borrow funds more cheaply because a greater portion of their assets has to be in default before they might fall.

Again he advised Bank Management by saying that liquidity planning focuses on guaranteeing that immediately available funds are available at the lowest cost. Management must determine whether liquidity and default risk premiums more than compensate for the additional risk on longer-term and lower-quality bank investments. If management is successful, long-term earnings will exceed peer banks' earnings.  In addition the bank's capital will increase resulting in overall better liquidity. The market value of bank equity will increase relative to peers as investors bid up stock prices.

4. GENERAL LIQUIDITY POLICIES

When liquidity needs are filled in an unplanned way (e.g., selling long-term investments or calling loans), shareholders' value is likely to be reduced. The damage to the shareholders' position from poor liquidity planning is particularly evident when failing to satisfy depositors' demand or not accommodating legitimate investment requests causes shortfalls.  The inability of an institution to satisfy depositors' withdrawal requests can lead to severe regulatory action, culminating in assumption or liquidation and thus, the complete destruction of shareholder's value. Inadequate funding of the investment portfolio disrupts customer relationships and could permanently reduce a bank's market share. However, this is not to say that liquidity policy should be completely defensive. On the contrary, a flexible liquidity strategy includes the ability to seize unexpected profit opportunities.

Timothy W. Koch (second edition, pp.483-85) mentioned that historically, liquidity management focused on assets and was closely tied to investment policies. Under commercial loan theory prior to 1930, banks were encouraged to make only short-term, self-liquidating loans. Such loans closely matched the maturity of bank deposits and enabled banks to meet deposit withdrawals with funds from maturing loans. An inventory loan, for example, would be repaid when the borrower sold the items that coincided with the need for financing to accumulate additional inventory. A bank was liquid if its loan portfolio consisted of short-term loans.

The shift ability theory represented the next extension by recognizing that any liquid asset could be used to meet deposit withdrawals. In particular, a bank could satisfy its liquidity requirements if it held loans and securities that could sell in the secondary market prior to maturity. The ability to sell government securities and eligible paper effectively substituted for illiquid, longer-term loans with infrequent principal payments.

Around 1950 the focus shifted to the anticipated income theory, which suggested that liquidity requirements and thus loan payments should be tied to a borrower's expected income. Banks were still encouraged to invest in marketable instruments but now structured loans so that the timing of principal and interest payments matched the borrower's ability to repay from income. The primary contribution was the emphasis on cash flow characteristics of different instruments because a borrower's cash flow generally varied closely with his or her income. This encouraged the growth in amortized loans with periodic interest and principal payment and staggered maturities in a bank's bond portfolio.

According to the liability management theory, banks can satisfy liquidity needs by borrowing in the money and capital markets. When they need immediately available funds, they can simply borrow from the central bank or other commercial banks. This theory became increasingly popular as banks gained the ability to pay market interest rates on large liabilities. The fundamental contribution was to consider both sides of a bank's balance sheet as sources of liquidity.

Today, banks use both assets and liabilities to meet liquidity needs. Available liquidity sources are identified as compared to expected needs. Management considers all potential deposit outflows and inflows when deciding how to allocate assets and finance operations. Key considerations include maintaining high asset quality and a strong capital base that both reduces liquidity needs and improves a bank's access to funds at low cost. 

5. DEMAND AND TIME LIABILITIES

Items in details under Demand and Time liabilities are shown below:

Various items of demand and time liabilities should be shown in the weekly statement of position as per the following classification:

A.      Demand Liabilities

a)      Demand Deposits (General)

i)                    All Current Accounts except from Banks

ii)                   All Investment (Cash Credit) Accounts Credit Balances

iii)                 Demand Portion of Savings Bank Accounts

iv)                 Overdue Fixed Deposits A/Cs

v)                   Call Deposits A/Cs other than from banks (on Demand)

vi)                 Unclaimed Balances A/Cs

vii)                Profit (Interest) accrued on above A/Cs.

viii)              All other Deposits payable to public on demand e.g. 

(1)          Outstanding Bills

(2)          Payment orders

(3)          Telegraphic Transfers

(4)     Outstanding Drafts

(5)     Drafts Payable Account

(6)     Demand Drafts

(7)     Hajj Deposits

(8)     Bonus Scheme Remittances Payable

(9)     Branch Remittances Payable

(10)   Bill Payable

(11)   Certificates Payable

b)      Deposits from Banks

i)                    Current Accounts and demand portion of savings account

ii)                   Call Deposits

iii)                 Profit (Interest) Accrued on Call Deposits

c)       Borrowings from Banks

i)                    Borrowings from Banking Companies

ii)                   Call Loans or sale of T.Ts. or D.Ds. (other than from Bangladesh Bank).

d)      Other Demand Liabilities (e.g)

i)                    Cash Security (Margin) on L/Cs

ii)                   Cash Security (Margin) on Guarantees

iii)                 Lockers Key Security Deposits

iv)                 Unclaimed Dividend/Dividend Payable

v)                   Credit Balance and Adjustment Account

vi)                 Security Deposit A/C (amount deposited by Supplier of Stationary and furniture etc. as security)

vii)                Sundry Deposits A/C

viii)              Any other miscellaneous deposits payable on demand 

B.       Time Liabilities 

a)      Time Deposits (General)

i)                    Fixed Deposits from Customers other than from banks      

ii)                   Special Notice Deposits other than those from other banks

iii)                 Time portion of the Savings Bank Deposits*

iv)                 Short Term Deposit A/Cs

v)                   Recurring Deposits

vi)                 Profit (Interest) accrued on all above accounts 

b)      Deposits from Banks

i)                    All Deposits from banking companies not payable on demand such as:

a)                  Fixed Deposits

b)                  Short Term Deposits

c)                   Special Notice Accounts

d)                  Time portion of Savings Bank Accounts 

ii)         Profit (Interest) accrued on all above deposits 

c)       Borrowings from Banks

i)                    Fixed Loans 

d)      Other Time Liabilities

i)                    Employees' Provident Fund Accounts

ii)                   Staff Pension Fund

iii)                 Employees' Security Deposits

iv)                 Staff Guarantee or Security Fund

v)                   Contribution towards Insurance Fund

vi)                 Any other miscellaneous liabilities payable on notice or after a specified period 

6. STATUTORY LIQUIDITY REQUIREMENT

            Statutory Liquidity Requirement (SLR) is determined on the basis of the assets and/or liabilities of the banks during an accounting period. This is composed of, as stated above, two terms viz., (a) Cash Reserve Ratio and (b) Supplementary Reserve Ratio. The current SLR in Bangladesh is 20% of the total demand and time liabilities. These ratios are explained thus.

6.1 Cash Reserve Ratio (CRR)

            Every deposit money bank (DMB) is required to place on deposit with the central bank a prescribed percentage of the bank's deposits.  In Bangladesh, the current percentage is 4 of the total demand and time liabilities. By varying this reserve, the central bank can either broaden the monetary base or sterilize part of the commercial bank's money creating powers.

Banks hold cash assets to satisfy four main objectives. First, banks supply coin and currency to meet customers, regular transactions needs. The amount of cash in a bank's vault corresponds to customers' cash deposits and the demand for cash withdrawals. Both exhibit considerable seasonal fluctuations, rising prior to holidays such as the Eid Festival. Second, regulatory agencies mandate legal reserve requirements that can only be met by holding qualifying cash assets. Third, banks serve as a Clearing House for the Nation's check payment system. Each bank must hold sufficient balances at the Central Bank so that checks written by its depositors will clear when presented for payment. Finally, banks use cash balances to purchase services from correspondent banks.

Obviously, banks prefer to hold as little cash as possible without creating shortage problems that would interfere with the daily operations. Since cash does not generate interest income, excess holdings have a high opportunity cost represented by the interest or profit that could be earned on an alternative investment. As the bank's reserve rises, so do the opportunity costs and the incentive to better manage the cash assets. There are, however, significant risks in holding too little cash. Imagine depositors' concerns if they were told that their bank did not have enough currency on hand for withdrawals. A bank must similarly keep enough deposit balances at the central bank to cover deposit outflows or it will be forced to replenish its balances under duress. Failing to maintain sufficient cash assets potentially creates liquidity problems and increases borrowing costs.

The amount of cash that management chooses to hold is heavily influenced by the bank's liquidity requirements. The potential size and volatility of its cash requirements in turn affect the liquidity position of the bank. Transactions that reduce cash holdings normally force a bank to replenish cash assets by issuing new debt or selling assets. Transactions that increase cash holdings provide new funds. From the opposite perspective, banks with ready access to borrowed funds can enter into more transactions because they can borrow quickly to meet cash requirements.

6.2 Supplementary Reserve Ratio (SRR)

Banks are required to maintain SRR on all days of the month amounting to 16% for the conventional banks and 6% for the Islamic banks of their total demand and time liabilities. The assets that are used by the DMB to meet this requirement in Bangladesh include:

(i)                  DMBs deposits with the central bank, commonly known as scheduled banks balances with the Bangladesh Bank (BB),

(ii)                Cash in tills or vault cash with the DMBs,

(iii)               Investments in Government Securities and treasury Bills,

(iv)               Investment in BB Bills,

(v)                Balances with Sonali bank as agent of BB,

(vi)               Benefits and barter accounts and Investment in unencumbered Approved Securities, and

(vii)             Any other Monetary and fiscal instruments as prescribed by the BB. 

Currently in Bangladesh, SRR is 16% for the conventional banks and 6% for the Islamic banks.

6.3 Calculation Procedure of SLR

      (A Hypothetical Example) 

The calculation for the appropriate reserve amount is calculated on Thursday, the last working day of the week, and is required to be kept on deposit throughout the next week until the reserve requirement is calculated again. In Bangladesh, Islamic banks are, as stated above, required to maintain 4% as CRR and 6% as SRR (SLR = 10%), whilst a conventional bank is required to maintain 4% as CRR and 16% as SRR (SLR = 20%). Calculation of SLR is illustrated in Tables 1 and 2.

Table - 1

Total Deposits of Private Commercial Banks

(AS on December 2000) 

1st Week	2nd Week	3rd Week	4th Week	5th Week	Weekly Average	Required Liquidity
1	2	3	4	5	6	7
22838.74	23056.09	23415.55	24110.85	0.00	23355.31	4671.06 (20%) 2335.53 (10%)

As depicted in Table 1, the weekly average of total deposits of the Private Commercial Banks (PCBs) stood at Tk. 23355.31 crores as on December 2000. The required level of SLR for the PCBs is Tk. 4671.06 crores as per 20% provision for the conventional banks, whilst the same for the Islamic banks is Tk. 2335.53 as per 10% provision. Of the 20% or 10%, each bank is required to maintain 4% of the SLR as CRR in cash as stated above. Therefore, after keeping 4% cash reserve with the BB as CRR (i.e., Tk. 186.84 crores) for the conventional banks or Tk. 93.42 crores for the Islamic banks, the remaining 16% or 6% (as the case may be) must be maintained as SRR.

In Table 2 are shown the breakdown of the demand and time liabilities of the PCBs. 

Table - 2

Breakdown of the Demand and time Liabilities of the PCBs

(As on December 2000) 

Deposits Including Inter-Bank Items	1st Week	2nd Week	3rd Week	4th Week	Average
Demand Liabilities 1         Deposits (General) 2         Deposits from Banks 3         Borrowings from Banks 4         Borrowings from the Non-banking Financial Institutions 5         Other Demand Liabilities Sub-total	3309.70 311.27 864.50 0.00   1526.91 6012.38	3388.97 389.34 857.50 0.00   1601.72 6237.53	3416.94 447.42 967.50 0.00   1652.93 6484.79	3697.28 379.27 863.50 0.00   1730.88 6670.93	3453.22 381.83 888.25 0.00   1628.11 6351.41
Time Liabilities 6. Deposits (General) 7. Deposits from banks 8. Borrowings from Banks 9. Other Time Liabilities Sub-total	17126.27 2417.33 66.75 875.66 20486.21	17172.66 2540.88 63.51 892.74 19777.05	17472.18 2664.83 63.28 873.50 21073.79	17800.91 3036.66 60.12 881.78 20897.69	17393.01 2664.93 63.42 880.97 20340.31
Total	26498.59	26014.58	27558.58	27568.62	26910.09
Deposits Excluding Inter-Bank items (Items: 1 & 5 + 6 & 9):       Demand Deposits        Time Deposits                Total	4836.61 18002.13 22838.74	4990.69 18065.40 23056.09	5069.87 18345.68 23415.55	5428.16 18682.69 24110.85	5081.33 18273.98 23355.31

 The contents of Table 2 gives that the average deposits to be considered as base figure for calculating SLR is Tk. 23355.31 crores. 

7. ALLOCATION OF RESERVES

7.1 Primary Reserve

 Once bank management has estimated the overall liquidity requirement, the first allocation of funds is made to primary reserves. This conceptual asset category includes vault cash, deposits at the central bank, balances with other depository institutions, and cash items in the process or collection. The high priority of primary reserves is the result of several factors: First, commercial banks are required by law to keep a specified percentage of total deposits in the form of primary reserves. Second, cash reserves are needed in the daily operations of commercial banks for paying and clearing checks. Finally, excess reserves may provide a first line of defense against unexpected deposit outflows or an unanticipated strengthening of investment demand.

7.2 Secondary Reserve

 Secondary reserves provide protective liquidity for forecastle cash needs as well as for more remote contingencies. Secondary reserves of traditional banks consist of short-term open market securities. Islamic banks can also hold Islamic bonds and securities like Mudaraba and Musharaka or other securities approved by Islamic Shariah. In contrast to primary reserves, secondary reserves can earn an explicit return, thus enhancing the profitability of the institution. The average maturity of the securities included in secondary reserves may vary. In addition to having near-term maturates, the securities in this category must have a low default risk and a market value with limited exposure interest rate movements. Being highly marketable and reversible, secondary reserves provide the commercial bank with its principal source of liquidity.

REFERENCES

1. Hornby, A.S.(1974 ). Oxford Advanced Learners' Dictionary. Oxford University Press.

2. Koch, Timothy, W., Bank Management, Second ed. (The Dryden Press, N.Y.).

3. Pandey, I.M. (Ed.) (1986). Financial Management. Vikash Publidhing House (Pvt) Ltd. New Delhi.

1. CONCEPT OF WORKING CAPITAL

Working capital may be defined as those assets held for current use within a business, less the amount due to those who await settlement in the short term for value supplied in whatever form. A business enterprise has to maintain an adequate amount of working capital to ensure its liquidity so that the firm does not face any difficulty to meet its current obligations.

There are two concepts of working capital namely gross working capital and net working capital. Gross working capital refers to the firm's investment in current assets. Current assets are those assets that can be converted into cash within an accounting year or within the operating cycle, whichever is greater. It includes cash in hand, cash at bank, bills receivable, sundry debtors, stock in trade, prepaid expenses, accrued incomes and temporary investments. The term net working capital implies the difference between current assets and current liabilities. Liabilities that are payable within the next accounting year or operating cycle are referred to as current liabilities and include bank overdrafts, short-term loans, outstanding expenses, advance incomes, bills payables, sundry creditors, dividends payable and taxes payable. When current assets are greater than current liabilities a firm has positive net working capital and vice versa.

Working capital is further classified into two categories; permanent and temporary. The amount of working capital that persists over time  regardless of fluctuations in sales is called permanent working capital. A trading firm, for example, has to maintain a minimum level of inventory to meet daily sales. This level of inventory is part of the firm's permanent working capital. The additions to inventory made for the holidays or festivals are part of the temporary working capital. In other words, temporary working capital is the additional assets required to meet variations in sales above the permanent ordinary levels.  

 2. NEED FOR WORKING CAPITAL  

Working capital may be regarded as the lifeblood of a business; its effective provision can do much to ensure the success of a business and while its insufficiency or insufficient management can lead not only to a reduction of profits, but also to the ultimate downfall of what otherwise might be considered as a promising concern. Businesses require working capital for the following reasons:

a)  It helps daily operation

Businesses require working capital to run day-to-day business activities. The purchase of raw materials, payment of wages and salaries, purchase of office supplies, payment of regular bills, rent, conveyance and transportation costs, and entertainment expenses are all examples of daily operations for which working capital is required.

b)  Investment in current assets

For many firms current assets constitute more than 50 percent of total assets or capital employed. For example, in India during the fiscal year 1975-76, 1650 large and medium public limited companies reported that current assets constituted 62 percent of total net assets.

c)  Full use of fixed assets

Given a fixed asset structure a firm is in need of sufficient amount of working capital to reach the maximum level or to ensure full use of its fixed assets. Under utilization of capacity due to insufficient working capital will simply increase fixed cost per unit resulting either in losses or at least a reduction in profit.

d)  Increasing sales

If a firm plans a special sales promotion, it must increase the amount of working capital to support the higher expected sales generated by the promotion or program.

e)  Payment of current obligations

Current obligations are claims that mature within the accounting year or operating cycle of a firm. Payments are made against these claims from the working capital fund. Long-term obligations like lease installments are also paid by working capital as they come due. In the absence of sufficient working capital, a firm having a lot of fixed assets could become technically insolvent if it is unable to make timely payment on it's current obligations.

f)  Supporting credit sale

In today's business world, the majority of sales are made on credit, which results in accounts receivable. The collection period of these receivables is determined by the terms of the credit sales. Depending on the terms of the credit arrangement, it could take weeks or even months before cash is received in final payment of the credit sale. Thus, having an appropriate level of cash to meet current obligations of the company is vital to the success of a business.

g)  Taking advantage of cash discount

Sometimes creditors or suppliers offer a cash discount, if payment can be made within a prescribed time. Thus, in order for a company to take advantage of a cash discount, it must have sufficient working capital.

h)  Hedging (advance purchase) against price fluctuations

Sometimes a trading firm has to make advance payment against a future supply of goods. These payments are made to ensure regular and timely supply of materials. Advance payment guarantees quality goods and sometimes is done to protect the company from price fluctuations.

i)  Facing unforeseen adverse conditions

From time to time a company is faced with some unforeseen circumstances. For example, a decrease in sales volume or fall in sales price may reduce the amount of expected revenue. Similarly a rise in the price of raw materials or labor will increase variable cost reducing the profit margin of the product. All these undesirable events have an adverse impact on the liquidity position of the company. A company may be able to absolve this shock if it maintains a reasonable level of working capital.

j)  Need for small firms

Small firms tend to rely more heavily on working capital since they are unable to secure long-term financing. Small firms generally have less fixed assets and higher current assets such as cash, accounts receivable and inventory. Small firms current liabilities are also more significant. Thus, working capital management is critical for small firms.

3. Guidelines for estimating working Capital  

There is no hard and fast rule in estimating the working capital investment of a firm. The factors that may be considered for estimating the amount of working capital are as follows.

Nature of Business: A trading firm such as a retail shop has very little investment in fixed assets but requires a large sum of money to be invested in working capital in the form of inventory. A service industry, on the other hand, depends less on working capital; examples of service companies are; Clinics & Hospitals, utility companies, hotels and transportation companies. These companies have huge fixed assets in their capital. The amount of working capital in the manufacturing industry as a percentage of total assets differs heavily from that of the mining industry. In 1983, current asset as a percentage of total assets for various manufacturing companies namely: aircraft, industrial, chemical and mining industries in the United States of America were 49.2%, 66.8%, 33.2% and 19.2% respectively.

Life Cycle: long-term securities increase. Inventories reach their peak proportion during The working capital need of an individual firm is also influenced by the stage of the industry's life cycle. The life cycle is generally divided into four phases. The level of working capital is highest during the early phases of the life cycle and diminishes as the firm matures. In the pioneering phase of development, the firm is small and holds a relatively large proportion of its asset in cash and accounts receivables. As the firm increases in size and maturity, the proportion held in cash and receivables declines sharply while funds invested in the expansion phase. The point is that the proportion and composition of working capital changes significantly over the life cycle of a firm.

Business Cycle: Changing business conditions also influence working capital decisions. In general, a firm's working capital needs increased during the recovery and prosperity stages of the business cycle when business activity is expanding and reduce during the recession and depression stages of the business cycle when business activity declines.

Operating Cycle: The operating cycle begins with the purchase of inventory and ends with the collection of receipts from goods sold. In other words the operating cycle is the time it takes to manufacture, sell and receive payment on the sale of a product. The longer the operating cycle of a company, the greater the need for working capital and vice versa. subtotal of average age of inventory and average age of receivables. Broader the operating cycle of a firm, larger the amount of working capital required and vice versa.

Size of Business: The size of business as measured by the scale of its operation is also a determining factor in calculating working capital needs. A firm with a larger scale of operation will need more investment in working capital than that of one with a smaller scale of operations.

Production Policy: Seasonal fluctuations affect the working capital requirement of the firm. During peak demand, increasing production may be expensive for the firm. Similarly, it is expensive during slack or down times when the firm has to sustain its work force and physical facilities without adequate production and sales. A firm may, follow a policy of steady production irrespective of the seasonal changes or it may adopt a varying production schedule in accordance with its changing demand. The point is that a company needs to take into consideration the firm's production requirements when estimating its working capital needs

Credit Terms: Credit policy greatly influences the working capital needs of the firm. A liberal credit policy will necessitate a huge amount of working capital in the form of accounts receivable. A tight credit policy will require a relatively lesser amount of working capital to be financed, as receivables will be collected more quickly. However, a tighter credit policy could also lead to lower sales. Thus, the firm should carefully consider the credit standards of its customers and other relevant factors, prior to determining its credit policy.

Availability of Credit: The working capital investment of a firm also depends on the availability of long term credit to the firm. Easy access to financial markets and strong relationships with its financial partners and creditors will reduce the need for high levels of working capital.

4. METHODS OF FINANCING WORKING CAPITAL

We now discuss the methods of financing working capital of Islamic and conventional banks. 

4.1 Conventional Banks 

When a firm does not have enough cash to meet short term operating obligations, it must borrow the cash needed in order to continue its operations.  The following is a discussion of various arrangements that can be utilized at a conventional bank.

      Overdrafts: The extension of financing through overdrafts can only occur when there is an existing demand deposit account. An overdraft occurs when the amount of a check presented for payment to the bank exceeds the clients deposit balance. The banks may choose to pay on the item, thereby causing a negative balance in the client's account.  This negative balance is effectively an extension of financing and can be a prior arrangement with the bank. In addition, overdraft facilities may be extended against deposit certificates and/or government promissory notes.

      Cash Credit: Cash credit is a popular mode of borrowing by traders, industrialists and agriculturalists. It is a separate account by itself and does not require having any other account with the bank. It resembles the use of overdrafts on a checking account. It is an arrangement whereby the borrower may withdraw funds as needed for day-to-day operations without the delay associated with making a loan. The borrower may not exceed a predetermined limit and must deposit cash back into the account as funds become available from daily operations.

Demand Loan: Sometimes conventional banks provide very short-term loans to its clients payable on demand.

Discounting Bills Receivables: Conventional banks discount bills receivables

Factoring Bills Receivables 

The chief disadvantages of these modes of financing are as follows:

      The borrowing firm has to pay a fixed rate of interest on the loan used to finance working capital needs. In other words, even if the borrowing firm does not make a profit on his investment, the firm still has to repay both the principal and the accumulated interest on the loan. The Shariah does not justify the payment of interest and it is also very difficult for a firm that is not profitable to satisfy the lender by repaying both principal and interest. The conventional bank is only interested in recovering its loan along with the interest profit. Thus there is less of a concern for the welfare of the business. In many cases, the conventional bank will request collateral to ensure repayment of the loan with interest.  

4.2 Islamic Banks  

Now, let us look at financing working capital needs through the Islamic banking system.

              Investment Mode: The Islamic Bank can meet a firms working capital needs with cash credit, over-draft and demand loan facilities on a profit/loss sharing basis (PLS). Under the PLS system, the entrepreneur can secure financing for his working capital needs in exchange for a share in the profits of his business. If the business results in a loss, he is not liable to pay anything to the bank. In fact, if the arrangement is one of Mudaraba, the bank incurs the entire loss. On the other hand, if the arrangement is one of Musharaka, the entrepreneur shares the loss with the bank.

              "Buy" Mode:  In addition, the firm can request that the bank purchase the goods on its behalf in exchange for repayment in lump sum or installments. There are two "buy" arrangements available to the firm. If the arrangement one of Murabaha, the bank purchases the goods and retains possession until the firm can pay the bank in full. On the other hand, If the arrangement is one of Muajjal, the bank buys the goods, but allows the firm to take possession of the goods in exchange for payment at a later date.

      Bills of Exchange: Islamic banks can also finance against bills receivables but they are not allowed to receive a discount on such an investment. However in this regard the council of Islamic Ideology recommends as follows: Since the bank accepts the responsibility of realizing the amount due to the drawer, from the drawee, it is permissible under the Shariah that the bank may realize a commission for rendering this service. This commission will be according to the amount of the bill but not according to the period of payment.

 

5. RISK INVOLVED IN MAKING WORKING CAPITAL INVESTMENTS

5.1 Risk of Selecting the Right Project 

While investing in working capital the bank professionals should be careful in evaluating the projects to be financed. Before selecting a firm for investment the short-term solvency and long term solvency should be measured with appropriate techniques. Short-term solvency of a firm is usually measured by working capital ratios while long-term solvency of a firm is measured by equity ratios. Firms with high debt ratios should be avoided while firms with low debt ratios in its capital structure should be accepted for working capital financing.

5.2 Selection of Appropriate Entrepreneur

Character of an entrepreneur is an important consideration for investment in working capital of a firm. Character, like reputation, refers to the borrower's honesty, responsibility, integrity and ability to manage the business. Investment worthiness is a combination of financial soundness and integrity of the entrepreneur. A capable, efficient and experienced, as well as honest, entrepreneur with a relatively weak financial background should be preferred to a dishonest entrepreneur with a strong financial background.

5.3 Mode of Investment

The type of financing to be used to fund a working capital request should be given careful consideration. The investment may be made in cash or in kind. Investments made in kind are less risky, but most Islamic banks choose to invest with cash. Cash investments involve the risk of the funds being used for a different purpose than was given to the bank. Thus, when cash is provided, the bank needs to ensure it is used for the purposes intended in the request.

5.4 Risk of Over- and under-Investment

The bank needs to give careful consideration to the amount of working capital being requested by the firm. If a firm borrows more than they actually need, the excess sits idle and carries with it the opportunity cost of other foregone investment opportunities. On the other hand, if the firm does not borrow enough, the business becomes unprofitable they are still unable to meet their operating needs. In either case, the banks anticipated return on the investment is less than it originally calculated. Thus, banks must verify that the amount of financing being requested meets the firm's needs. 

6. Working Capital Finance Against Receivables

Islamic banks can finance the working capital requirements of a firm with receivables as collateral. Receivables can take two forms. Accounts receivables means the amount of trade credit recorded on the balance sheet of the seller. Bills receivables, on the other hand, is that part of accounts receivables which is drawn as a bill by the seller and accepted by the drawee to pay a fixed amount after a certain period. Bill receivables are a kind of negotiable instrument generally accepted as collateral by traditional lenders. 

There are two methods found in modern finance literature to finance against receivables:

(i)         Pledging, and

(ii)       Factoring.

These methods are discussed as under.

6.1 Pledging

            Types of pledging

 Seasonal basis: This is a type of arrangement where occasionally receivables are pledged and there is no continuity. Each installment is considered as an independent pledge. After one pledge is over a fresh contract is required between the bank and the client to effect another pledge. The new contract is initiated with new terms and conditions.

             Continuous basis: This is an arrangement whereby a chain of pledging one after another occurs. For example, a borrower has a 5 lacs continuous pledge with a bank. Suppose at sometime in the future, receivables worth Tk 2 lacs is collected and settled. The client is required to deposit another two lacs worth of similar receivables to the bank within the context of the existing terms and conditions. In this way the receivables remain at the same level throughout the financing arrangement.  

Things to be Satisfied by the Bank for Pledging

? Goodwill of the drawee firm of the bill

? The period of transaction between the drawer firm and the drawee firm

? The solvency of the firm which is offering the pledge

            ? That the bill being placed for pledging is not an outdated one. 

 Cost of Pledging with Conventional Banks

?  Interest cost: Interest cost of pledging is higher than normal  rate of interest on loan

? Service charge: This includes filing cost, correspondence cost and cost of collection by the bank on behalf of the seller.

Cost of Pledging with Islamic Banks

? As previously mentioned, it is not appropriate for Islamic banks to charge interest or Riba on a financing arrangement. However, the bank can participate in the profit and loss of the investment on a Mudaraba basis. In addition, the bank can also charge a commission from the client if the bank is assigned to collect the amount of the bill from the drawee.   

6.2 Factoring

Factoring simply means selling the bills receivables to a factor to meet the financing need. Generally the commercial banks or finance companies act as a factor. Factoring is popular in developed countries. Factoring is mostly practiced in manufacturing industries like textile, furniture, shoe and floor covering.  

Methods of Factoring and Factoring Cost

Under the conventional system when bills receivables are placed for factoring, the factor scrutinizes the merits and quality of the bills being sold. If the factor is satisfied with the quality of bills than he claims:

a) A certain percentage commission on the face value of the bill

b) A precautionary reserve (say 10%) of the total amount of bills to be factored

c) A certain percentage of interest on an advance amount to be paid by the factor (bank) to the seller of the bill receivable.

Advantages of Factoring

            ?  Flexibility

?  No interest for compensating balance

?  No restrictive conditions

?  No cost for collecting bills receivables

Disadvantages of Factoring

?  High cost

? Selective factoring: That is, factoring is available only for the firms with strong financial background and sound lending policy.

It should be noted that factoring is not permissible by Islamic banks, because it is not compatible with the Shariah.

Caution for Investment Against Receivables

Before accepting bills receivable as a pledge, two things should be taken into consideration by the investment banker, First, the credit rating of the owing firm should be evaluated. The credit rating of a firm is a function of goodwill, financial solvency, regularity of cash inflow and previous repayment record. Second, the age of the bills receivables should also be carefully looked into so that bills from firms with a weak credit rating and substantially overdue bills may not be accepted as collateral. Most investors prefer to invest against a few receivables from well-established companies that do not customarily return the merchandise they have purchased.

Generally the amount of investment is less than the full face value of the bills receivable pledged as collateral, the percentage that the investor is willing to invest depends on the size, number and quality of the receivables.   

If an Islamic bank wants to invest to meet the working capital requirement of a manufacturing firm or industry it must carefully study the working capital management of the concerned organization. In this regard the following issues related to management of receivables should carefully be observed:

      Credit policy of the firm: A firm may have a strict or liberal credit policy. A liberal credit policy generates higher sales and profit as compared to a strict credit policy. However,  a firm can incur higher costs in the form of bad debt, losses and liquidity problems with a liberal credit policy. A strict credit policy, on the other hand, minimizes the cost of bad debts and problem of liquidity, but it also restricts sales and profits. So, the firm whose credit policy has been determined by a reasonable trade-off between liquidity and profitability should get priority to the investment portfolio of an Islamic bank.

      Credit standard: Islamic banks must also look at the credit standard maintained by the firm applying for the working capital investment. A firm may sell on credit to any firm indiscriminately or it may be selective as to whom it extends credit. A liberal credit policy of a firm generates a high level of sales and receivables and vice versa. But it increases the risk of bad debts as well. The Islamic bank should prefer those firms who follow a strict credit standard when considering a loan against receivables.  

7. INVESTING FUNDS AGAINST INVENTORY

Qualities of inventories to be mortgaged for financing

Loans can also be made with inventory as collateral. An Islamic bank must take the following things into consideration when considering/making a loan collateralized by inventory.

            Durable: The bank must be sure that the inventories being mortgaged are durable goods and not perishable in nature.

            Easily identifiable: If the inventory differs in terms of quality, size, color, or some other characteristics, then the amount of inventory earmarked to be mortgaged must be clearly described so that no confusion arises during the identification of the item.

            Easily marketable: The item of inventory being mortgaged must be of such quality and nature that it can be sold easily in the market. For example, clothing is more marketable than printing machines and computers are more marketable than electronic type-writers. 

8. CLASSIFICATION OF MORTGAGES

8.1 Floating Lien

 All inventory of the borrowing firm is automatically brought under this mortgage. Goods remain in the hands of the borrower. The borrower can produce by using raw inventories and can sell finished inventory, but the proceeds of the sale should be paid to the lender. Any new purchase of the borrowing firm comes automatically under the fold of the present mortgage. 

Advantages of Floating Lien

? The borrower can obtain more credit/investment by mortgaging all its  inventory.

? The Mortgagor could sell the mortgaged goods. In other words, this type of mortgage does not interrupt normal business activities.

Disadvantage of Floating Lien:

? The lender usually only extends a loan up to 60% of the value of the inventory.   

8.2 Trust Receipts

In this case a particular item (no