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CREDIT EVALUATION:

WORKING CAPITAL FINANCE

Working Capital can be defined as Gross


Working Capital & Net Working Capital.
Gross Working Capital is investment in Current
Assets of the firm e.g. inventories, receivables,
marketable securities, Advance Tax paid etc.
Current Assets are those assets which normally
get converted into cash within a year.
Net Working Capital (NWC) refers to the
difference between Current Assets and Current
liabilities. Current liabilities are those claims of
the outsiders which are expected to mature for
payment within one year and include, creditors,
bills payable, short term bank finance and
expenses outstanding. NWC

Is also referred to as Liquid Surplus by the


Bankers. It is the amount of surplus funds
from long term resources of the firms,
which are used to finance the Current
Assets of the firm.
ASSETS
LIABILITIES

Capital &
Reserves

Fixed Assets

_________________________ _________________________

Misc. & Non C A

Deferred
Liabilities

_________________________

.
__________________

Current Assets

Intangible Assets
__________________

Working Capital Gap: This is difference


between Current Assets and Spontaneous
Current Liabilities (i.e. current liabilities
other than short term bank finance) and is
financed by NWC & short term bank finance.
Thus Working Capital required by a unit is
Total amount of investment required in its
Current Assets, which depends on:
(a) The volume of activity (viz. level of
operations i.e. production & Sales)
(b) The activity carried on viz.
mfg.process,product, production
programme, materials and marketing mix.

Further, Total Working Capital is finance by:


(a) Net Working Capital (Liquid Surplus)
(b) Spontaneous Current Liabilities
(c) Short Term Bank Finance
OPERATING CYCLE:
Any manufacturing cycle is characterised by a
cycle of operations consisting of purchase of
raw materials Converting these into finished
Goods and realising cash by sales of these
finished goods.
Cash ---Raw material ---Stock in process
---Finished Goods ---- Bills Receivable ---Cash
The time that lapses between cash outlay and
cash realisation by sale of finished goods and
realisation of receivables is known as length of
operating cycle.

Thus Gross Working Capital Operating


Cycle = Average Raw material storage +
AverageConversion Period +Finished
Goods Storage Period + Average
Receivable Period
Unit may also avail of credit purchases
instead of cash purchases. Thus if we
deduct from Gross Working Capital
Operating Cycle, Average payment period,
it will give us Net operating Cycle.
ILLUSTRATION:
The following data has been extracted
from the books of ABC Ltd.:

PARTICULARS:
1. Opening balance of:
a. Raw material stores and
spares
b. Work-in process
c. Finished Goods
d. Accounts receivable
e. Accounts payable
2. Closing balance of:
a. Raw material, stores and
spares
b. Work-in process

Amt. in
lacs
3500
60
650
760
2500
4100
70

C. Finished Goods
d. Accounts receivable
e. Accounts payable
3. Purchases of Raw material
& Store
4. Manufacturing expenses
5. Depreciation
6. Customs & Excise duty
7. Selling, administration &
Finance expenses
8. Sales

1030
1160
3080
10700
1150
250
35000
4560
55,000

A. Raw material storage period:


1. Average stock of raw material=
(3500+4100)/2=3800
2. Annual Consumption of Raw material= Opening
stock + Purchases closing stock = 3500+107004100= 10100
3. Average daily consumption of Raw
material=10100/360 = 28
4. Raw material storage period= 3800/28=136 days
Average conversion or work in process period:
1.Average stock of work in process= (60+70)/2=65
2.Annual cost of production= Opening stock of
WIP+

+Consumption of materials+Manufacturing
expenses+Depreciation-Closing WIP=
60+10100+1150+250-70 = 11490
3. Average daily Cost of
production=11490/360=31.92
4. Average Conversion period= 65/31.92= 2 days
C. Finished Goods Storage period:
1.Average inventory of Finished
goods=(650+1030)/2=840
2.Annual cost of sales=Opening stock of FG+Cost
of production+Selling,admn.&Financial
expenses+Custom and excise duty-Closing stock
of FG = 650+11490+4560+35000-1030=50670
3.Average daily cost of sales=50670/360= 140.75

4.Finished Goods storage period=


840/140.75=
6 days
D. Average Collection period:
1. Average Book debts = (760+1160)/2 = 960
2. Annual Sales = 55,000
3. Average daily sales= 55000/360 =152.78
4. Average Collection period = 960/152.78 = 6
days
E. Average payment period:
1. Average Balance of Trade creditors
=(2500+3080)/2= 2790
2.Annual purchases= 10700

Average daily purchases = 10700/360 = 29.72


Average payment period = 2790/29.72 = 94
days
Gross WC operating cycle period =136 + 2 + 6
+ 6 = 150days
Net WC Operating period = 150 94 = 56 days
Total AnnualOperating expenses of the
Company = 10700+ 1150+ 35000 + 4560 =
51410
Total operating cycles on the basis of Gross
Working Capital cycle in the year = 360/150 =
2.4
Hence Gross Working Capital required =
51410/2.4 = Rs.21421 lacs

Another method to calculate Gross


Working Capital requirement:
Raw material monthly cost = Annual
consumption/12 = 10100/12 = Rs.842
Monthly manufacturing expenses =
1390/12 = Rs. 116
Monthly Selling, Administration & Finance
expenses, Custom & Excise duty= (35000
+4560)/12= Rs.3297
Monthly profit = Monthly sales Monthly
RM-Monthly mfg.exp Monthly other
expenses =(55,000/12)-842-116-3297 =
Rs.328

(Rs. In lacs)

Input
1.RM:
In
stock
In wip
In FG
In Drs.

Perio RM
d
136 381
d
7
2d
6d
6d

WIP FG

DRS Tota
.
l

56
168
168
420
9

(Rs./lacs)
Input

2.Mfg
exp.
In WIP
In FG
In Drs.

Period RM

1d
6d
6d

WIP FG

Drs. Total

4
23
23
50

3.Sellin
gadmn
ex
In FG
In Drs.

6d
6d

66
0 660
13
20

(Rs./lacs)
Input
4.Profit
In Drs.

Perio RM
d
6d

WI FG Dr Tota
P
s
l
66
66

TOTAL:

381 60 85 91
7
1 7

56
45

Manufacturing in WIP are taken as half as they


are expected to occur evenly during the total
period.
Since that there is lot of difference regarding
Working Capital required by the above two
methods, main distortion has occurred
because of high stocking period of RM and
Excise & Custom expenses.
Traditional method of Assessment of WC:
The operating cycle concept serves to identify
the areas requiring improvement for the
purpose of control and performance review.
But, as bankers, we require a more detailed
analysis to assess the various components of
working capital requirement viz. finance for
stocks, bills etc.

Bankers provide Working Capital finance for


holding an acceptable level of CA for achieving
pre-determined level of production and sales.
Quantification of these funds required to be
blocked in each of these items of CA at any
time and will therefore provide a measure of
the Working Capital requirement.
Raw Material: Factors affecting stocking
Average Consumption, Availability
Locally/Outside/ indigenous/imported , lead
time, EOQ, Credit/Cash, seasonality etc. (So
many months consumption)
WIP: Processes i.e. Technology, Processing
Time, Number of Products handled, Average
quantity of

Each product, Number of shifts


A rough and ready method of computing the
requirement of funds is to find out the cost of
production for the period of processing, viz.(Raw
material consumed per month + expenses per
month)x period of processing in months.
Finished goods: Stocking depends upon: Firm
order/anticipated order, supply terms, minimum
quantity that can be dispatched in one lot,
Transport availability , inspection, seasonality,
variation in demand, Peak level/low level of
operations, Marketing arrangement e.g. direct
sales to consumers or through wholesale
dealers

The requirement of funds against finished goods


is expressed as so many months cost of
production.
Sundry Debtors (Receivables):
Sales may be affected (a) against advance
payment-No funds blocked up, instead helps in
meeting working capital needs (b) Against cash
No funds blocked (c) On credit Funds are
blocked; extent of credit depends upon Trade
practices, market conditions, whether bulk
purchase by the buyer, seasonality(rain coats,
woolen products), price advantage etc.
Even though the amount of sundry debtors
according to the units books will be on the sales
price, the

Actual amount blocked will be only cost of


production of the materials the difference being
the units profit margin.
The Working Capital requirement against sundry
debtors will therefore be computed on the basis of
cost of production (whereas the permissible bank
finance will be computed on the basis of sale
value). The working capital requirement is
expressed as so many months cost of production.
EXPENSES: It is customary in assessing the working
capital requirement of industries to provide for
ONE MONTHS EXPENSE(Salaries, admn. Etc.) also.
This amount is provided merely as a cushion, to
take care of temporary bottlenecks. This amount
can be reduced

Or increased depending upon the operating


cycle.
Credit received: Trade credit received depends
upon trade practices in a particular industry and
also varies from place to place. Secondly,
industry often receive advance payment against
orders. The same may be appropriately adjusted
while assessing the permissible bank finance.
Traditional Method of Working Capital
requirement is normally applicable to Industries
with Working Capital requirement up to 5 crs.
ILLUSTRATION:
Name of the Unit: ABC Ltd. (Rs.in 000)
Anticipated monthly sales:Rs.100 (Sales to be

Computed at the maximum level of


anticipated production during the next 12
months)
Cost of production per month: Rs.90
(includes cost of raw material and other
manufacturing expenses)
Perio per
WC month
Mar :Mar
PBF
ITEM
Cost of raw material
Rs.80
d
reqd gin gin
.
%
Imported RM

--

Indign RM

1m

80

25

20

60

WIP

2W

45

25

11

34

FG

2W

45

25

11

34

Item

Receivable(S
V)
Expenses
Total:
Less:
Advance
received
Less: Credit
on purchase
WC required

Perio WC Mar
d
reqd gin
.
%

Mar
gin

PBF

1m

90

33

23

67

1m

10

100
%

10

75

195

270
40

10
220

Sources:
Let us say liquid surplus from B/S
= 20
Limits from Bank
=195
Total
=215
Net Deficit (220-215)
=
5
How the deficit will be met: Deficit have to be
met by plough back of profits or unsecured
loans. Deficit should be reasonably small, when
compared to the WC required.
Bank may reduce the PBF in case if liquid
surplus available is more than the gap between
WC required and PBF calculated.

Projected Annual Turnover method for SSI


units (Nayak Committee):
As per Nayak Committee Report pertaining to
SSI units, minimum working capital requirement
for WC limits up to Rs. 5 cr, is 25% of projected
annual turnover of the unit; out of which 5%
should be brought in by the promoters from
liquid surplus and 20% should be financed by
the bank.
ILLUSTRATION:
(Rs.000)
Projected annual Turnover
1200
(A)
Working Capital requirement
(25% of A)
300
(B)
Less: Liquid surplus or 5% of
A (whichever is higher) say liquid
Surplus is Rs.20,000/60
(C)
Minimum PBF
240

Clarification: RBI instructions to the Banks: In


case of limits to SSI units upto Rs.5 cr,
assessment should be done both by Turnover
method (Nayak Committee) and by
Traditional method. The higher of the two
should be sanctioned as Working Capital limit
by the banks.
It should be ensured that the projected
annual turnover is reasonable and achievable
by the unit. Any projections say beyond 15%
of the previous years actual or current years
estimates would need closer look.
The entire sales proceeds should be routed
through Cash-Credit Account.

Sub Limits : The fixing of sub-limits against the


stocks, receivables etc. will be decided as
warranted.
Drawing Power: Drawing power in the account
will be regulated as per drawing power arrived
at, after providing for the security margin.
However, sales data should be obtained every
month and compared with the projections.
Seasonal Industries:
The peculiarity of the particular industry has to
be taken into account. In case of seasonal
industries, the peak season and off season
turnover instead of annual turnover can be
separately considered for determining the
respective turnover level.

Most of the banks have now extended turnover


method for sanctioning WC limits up to Rs.5 cr
to other units also apart from SSI units.
However, in case of Trade & Services sector,
Working Capital limit up to 15% instead of
20%of projected annual turnover is being
sanctioned by the banks.
TANDON AND CHORE COMMITTEE
RECOMMENDATIONS:
Tandon committee was appointed by GOI to
suggest method of assessing working capital
requirement and approach to lending for the
industries, since at that time banks resources
were scarce. The committee was also asked to
devise an information system that would
provide periodically, operational data, business
forecasts, production plan and

Resultant credit needs of the units. Chore


committee which was appointed later, further
refined the approach to working capital
assessment. The MPBF method is fall out of the
recommendations made by Tandon and Chore
Committees.
Tandon committee also recommended
inventory/receivables norms for 22 major
industries.
Approach to lending: Tandon committee gave 3
methods of assessing the MPBF:
(i) MPBF = 0.75 (CA CL)
(ii) MPBF = 0.75 (CA) CL
(iii) MPBF = 0.75(CA CCA) CL
CCA (Core Current Assets) to be financed by LTF
Till recent past the banks were required by RBI to
use

Tandon committee method II for computing


MPBF which gives Current ratio of 1.33.
However, banks are now free to use their own
policy of calculating MPBF. Also the
inventory/receivables norms given by Tandon
committee have become redundant and banks
now finance these according to acceptable level.
ILLUSTRATION:
ABC LTD. have CA 200 lacs, SCL 40 lacs and CCA
56 lacs. Calculate MPBF and NWC required under
all the 3 methods prescribed by Tandon
Committee.
Method I MPBF = 0.75 (200 40) = Rs.120 lacs

NWC = 200-40-120 = Rs. 40 lacs

Current Ratio = 200/160 = 1.25


Method II = MPBF = .75 (200) 40 = Rs.110
lacs

NWC = 200-40-110 = 50
Current Ratio = 200/150 = 1.33
Method-III MPBF = .75 (200 56) -40 = Rs.68
lac

NWC = 200-40-68 = Rs.92 lacs

Current ratio = 200/108 = 1.85


Method I and Method II will always given Current
ratio of 1.25 and 1.33 resp. However, in method
III CR will depend upon level of CCA; higher the
CCA, higher will be CR. But in any case Method
III will always give CR higher than method II.

Method of lending : Financing of WC by the


banks will be through Cash-Credit (CC), Working
Capital Demand Loan (WCDL) and /or bill
financing mechanism. In CC limit there will be
lot of uncertainty about cash inflows and
outflows resorted to by the Company, resulting
in uncertainty in interest income of the bank
from the facility. To avoid this, RBI introduced a
system of loan delivery system for the banks,
where Working Capital loans up to Rs.10 crs are
extended to the borrowers-a portion as CC Limit,
a portion as WCDL and remaining if necessary as
bill financing. WCDL has a minimum repayment
period of 15 days and can be repaid in
instalments or bullet repayment at maturity.
WCDL

Can also be rolled over. The disbursement of


WCDL is normally based on the projected
cash budget statements and Quarterly
information/Operating system.
Working Capital facilities are renewed
annually. Depending on projected operations
of the unit, WC limit can be enhanced,
reduced or maintained at the same level.
In consortium lending CC limits and
WCDL/Bill financing limits are share by the
consortium banks on pro-rata basis.
Ad-hoc limits for short time requirements
can also be extended to the borrowers but
only after regular limits have been fully
utilised by them.

Assessed Bank Finance (ABF)/Projected


Balance Sheet (PBS) Method:
Normally Applicable to Working Capital Limits
above Rs. 5 cr
The borrowers total business operations,
financial position, management capabilities are
analysed in detail to assess the Working Capital
requirement and to evaluate the overall risk of
the exposure: (a) Analysis of borrowers P&L A/c,
B/Sheet, Ratio Analysis, Funds flow etc. for the
past periods is done to examine profitability,
financial position, financial management etc. in
the business (b) Detailed scrutiny and validation
of projected income, expenses, Sources and
uses of cash are carried out to examine
acceptability from the angle of liquidity

Overall gearing, efficiency of operations.


The assessment procedure is as follows:
Collection of financial information from the
borrower
Classification of CA & CL
Verification of projected levels of inventory/
receivables/sundry creditors
Evaluation of liquidity in the business
Validation of Bank finance sought.
Fixing of sub limits viz C/C, WCDL, Bill finance
(i) Current liabilities would also include accrued
amounts which are anticipated to cover known
obligations e.g.provisions, accrued bonus
payment

Taxes etc. In case where specific provisions are


not made for these liabilities and will be
eventually paid out of General reserves,
estimated amounts should be transferred to
CL.
(ii) Investment in shares and advances to other
companies should be excluded from the CA
(iii) Advances paid for supplies for a period
more than trade practice should be excluded
from CA
(iv) Progress payments received if shown
separately on liability side should be set-off
against work-in-progress. Outstanding advance
payments received are to be reckoned as CL
or otherwise, depending upon whether they
are adjustable within a year or not, or later.

(v) Any deposit from the Dealers be


treated as Term liability.
(vi) Any security deposit/tender deposit
made by the Company be treated as NCA .
(vii) Advance tax paid should be net-off
against provisions.
(viii) Provision of disputed excise duty etc.
should be classified as CL, unless paid over
in instalments beyond a period of 12
months.
(Ix) Fixed Deposits with banks investment
in MF, CD,CP may be classified as CA. ALL
other investments be treated as NCA.

Verification of level of
inventory/receivables/sundry creditors:
Projected level of above are examined in
relation to past trend, inter-firm comparison etc.
In case if levels seem to be non realistic, the
same be discussed with the borrower and if
required revised.
Evaluation of liquidity: Bench mark CR is
1.33. But in deserving case, if the proposal is
otherwise acceptable and there are genuine
reasons for low CR e.g. heavy TL instalments to
be paid in next 12 months or large provisions
etc. a lower than CR may be acceptable.
Sometimes, proposal is sanctioned with a
condition that the unit will induct more long
term funds to improve CR in a specified period
of time.

ILLUSTRATION:
ABC Ltd. has applied to the Bank for
Working Capital Limit and submitted the
projected data to the Bank. Bank analysed
the data and after thorough scrutiny,
accepted it as follows:
Item
Amt.
Holdin

Rs/crs
g
period
Raw material
(Indigenous)
Raw material
(imported)
Overall Raw
material

38.94 1.09 m
20.96 2.96 m
59.90

1.39
m

Receivables
(Domestic)
Receivables (Export)
Other Current Assets
Sundry Creditors
Other Current
Liabilities
Total Current Assets
(CA)
Spontaneous
Current Liabilites
(SCL)

183.64
52.32
34.26
20.71
340.80
54.97

3.00 m

0.79 m

Working Capital Gap (WCG) = CA SCL =


340.80-54.97 = 285.83 cr
Working Capital Gap will be financed by Net
Working Capital (Liquid Surplus) + Working
Capital Finance from Bank.
Let us say Bank maintains a Current Ratio of
1.33 (Tandon Committee II)
1.33 = Current Assets/(Spontaneous CL +Bank
finance) =340.80/(54.97 + Bank finance)
1.33Bank finance + 73.11 = 340.80
Bank Finance = (340.80 73.11)/1.33 =
Rs.201.27 cr
Hence maximum Working Capital finance
extended by the Bank will be = Rs.201.27 cr
(Say Rs.200 cr)
Liquid Surplus = WCG Bank Finance

= 285.83 200 = Rs.85.83 cr


Let us say existing liquid surplus with the
Company i.e. LTF LTU = Rs. 60 cr
Deficit = 85.83 60 = Rs.25.83 cr. Hence
ABC Ltd will arrange long term funds
amounting to Rs.25.83 cr. (including
plough back of projected profits)
Let us say existing liquid surplus is Rs.90
cr. ABC Ltd. will be sanctioned Working
Capital Limit equal to = WCG Liquid
Surplus = 285.83 90 = Rs.195.83 cr and
not Rs.200 cr

Inadequate Working Capital: It may lead to


following problems:
Cash Discounts: Unit may not be able to avail of
available cash discounts.
Production facilities: Unit may not be able to
take advantage of optimum production facilities
because of bulk purchase of raw material etc.
This may affect the profitability of the unit
which may further affect the liquidity of the
unit.
Payment of short term liabilities: The same may
get affected and the unit may resort to
borrowing from outside at higher interest rate,
affecting its profitability and good-will in the
market.

Inability to meet debt obligations may also


result in winding up of the unit.
Fixed assets are not efficiently or effectively
utilised.
Excessive Working Capital: It may lead to
Overtrading by the unit which may result in
losses.
Accumulation of inventories, leading to higher
warehousing rent, insurance cost, loss due to
theft etc.
Higher production, over supply and crash in
prices
Idle funds with the unit affecting profitability.
Carelessness in cost of production.