Working Capital Requirments

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A Project Report

On

Study of assessment methods of working capital requirement

For

Bank of Maharashtra

By

Vaibhav N Jagat

Under the guidance of

Mrs. Sovani

Submitted to

University of pune

In partial fulfillment of the requirement for the award of the degree of master of

business administration (MBA)

Through

Vishwakarma institute of management

Pune- 48

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In this project I have considered various banking facilities for the working capital

finance to the industries. It covers almost important aspect relating to assessment & follow

up of working capital finance. After discussing the procedure followed by bank, For

assessing working capital requirement case studies have been given with necessary data in

the prescribed forms demonstrate the calculable done by bank to arrive at maximum

permissible bank finance. An inventory & receivables constitute the major portion of the

total working capital requirement.

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Company Profile

The Birth

Registered on 16th Sept 1935 with an authorized capital of Rs 10.00 lakh and commenced

business on 8th Feb 1936.

The Childhood

Known as a common man's bank since inception, its initial help to small units has given

birth too many of today's industrial houses. After nationalization in 1969, the bank

expanded rapidly. It now has 1292 branches (as of 30th September 2005) all over India.

The Bank has the largest network of branches by any Public sector bank in the state of

Maharashtra.

The Adult

The bank has fine tuned its services to cater to the needs of the common man and

incorporated the latest technology in banking offering a variety of services.

Our Philosophy

o Technology with personal touch.

Our Emblem

The Deepmal

o With its many lights rising to greater heights.

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The Pillar

o Our institution- Symbolizing strength.

The 3 M's

Symbolising

Mobilisation of Money

Modernisation of Methods and

Motivation of Staff.

Our Aims

The bank wishes to cater to all types of needs of the entire family, in the whole country. Its

dream is "One Family, One Bank, Maharashtra Bank".

The Autonomy

The Bank attained autonomous status in 1998. It helps in giving more and more services

with simplified procedures without intervention of Government.

Our Social Aspect

The bank excels in Social Banking, overlooking the profit aspect; it has a good share of

Priority sector lending having 46% of its branches in rural areas.

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Other Attributes

Bank is the convener of State level Bankers committee

Bank has signed a MoU with EXIM bank for co-financing of project exports

Bank offers Depository services and Demat facilities in Mumbai.

Bank has captured 97.68% of its total business through computerization.

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OBJECTIVES

To know the various types of working capital finance provided by banks.

To analyze in detail the procedure of assessment of working capital finance

extended by bank.

To apply these procedure at a practical level with the help of case studies.

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RESEARCH METHODOLOGY

This is analytical research area where we analyses information with cause and its

effects relationship. This analysis leads to the simple conclusions of whether to lend money

to the institution for business.

Also if the money is lend then there is reality the norms are not always perfect and

hence it is essential to priorities stringent parameters and secondary parameters.

Research Type Analytical

Source of Data Primary and Secondary

Sample Unit Industries applying for loan

Sample Case studies

Sample Technique Allocation of Case

Analysis Tool used Financial Analysis

Primary Data:

Observation, Discussion with the manager.

The company profile, annual reports have been obtained from BOM.

Secondary Data:

Secondary data relating to the procedure of assessment of working capital finance, old

sanction proposals, RBI guidelines etc. have been sourced from reference books.

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INTRODUCTION TO WORKING CAPITAL

In accounting, Working capital is the difference between the inflow and outflow of funds.

In other words, it is the net cash inflow. It is defined as the excess of current assets over

current liabilities and provisions. In other words, it is net current assets or net working

capital.

A study of working capital is of major importance to internal and external analysis because

of its close relationship with the day-to-day operations of a business. Working Capital is

the portion of the assets of a business which are used on or related to current operations,

and represented at any one time by the operating cycle of such items as against receivables,

inventories of raw materials, stores, work in process and finished goods, merchandise,

notes or bill receivables and cash.

Working capital comprises current assets which are distinct from other assets. In the first

instance, current assets consist of these assets which are of short duration.

Working capital may be regarded as the life blood of a business. Its effective provision can

do much to ensure the success of a business while its inefficient management can lead not

only to loss of profits but also to the ultimate downfall of what otherwise might be

considered as a promising concern.

The funds required and acquired by a business may be invested to two types of assets:

1. Fixed Assets.

2. Current Assets

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Fixed assets are those which yield the returns in the due course of time. The various

decisions like in which fixed assets funds should be invested and how much should be

invested in the fixed assets etc. are in the form of capital budgeting decisions. This can be

said to be fixed capital management.

Other types of assets are equally important i.e. CurrentAssets.

These types of assets are required to ensure smooth and fluent business operations and can

be said to be life blood of the business. There are two concepts of working capital Gross

and Net. Gross working capital refers to gross current assets. Net working capital refers to

the difference between current assets and current liabilities. The term current assets refers

to those assets held by the business which can be converted into cash within a short period

of time of say one year, without reduction in value. The main types of current assets are

stock, receivables and cash. The term current liabilities refer to those liabilities, which are

to be paid off during the course of business, within a short period of time say one year.

They are expected to be paid out of current assets or earnings of the business. The current

liabilities mainly consist of sundry creditors, bill payable, bank overdraft or cash credit,

outstanding expenses etc.

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NEED FOR WORKINGCAPITAL

The need of gross working capital or current assets cannot be overemphasized. The object

of any business is to earn profits. The main factor affecting the profits is the magnitude of

sales of the business. But the sales cannot be converted into cash immediately. There is a

time lag between the sale of goods and realization of cash. There is a need of working

capital in the form of current assets to fill up this time lag. Technically, this is called as

operating cycle or working capital cycle, which is the heart of need for working capital.

This working capital cycle can be described in the following words.

If the company has a certain amount of cash, it will be required for purchasing the raw

material though some raw material may be available on credit basis. Then the company has

to spend some amount for labour and factory overheads to convert the raw material in work

in progress, and ultimately finished goods. These finished goods when sold on credit basis

get converted in the form of sundry debtors. Sundry debtors are converted in cash only

after the expiry of credit period. Thus, there is a cycle in which the originally available cash

is converted in the form of cash again but only after following the stages of raw material,

work in progress, finished goods and sundry debtors. Thus, there is a time gap for the

original cash to get converted in form of cash again. Working Capital needs of company

arise to cover the requirement of funds during this time gap, and the quantum of working

capital needs varies as per the length of this time gap.

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Thus, some amount of funds is blocked in raw materials, work in progress, finished goods,

sundry debtors and day-to-day requirements. However some part of these current assets

may be financed by the current liabilities also. E.g. some raw material may be available on

credit basis, all the expenses need not be paid immediately, workers are also to be paid

periodically etc. But still the amounts required to be invested in these current assets is

always higher than the funds available from current liabilities. This is precise reason why

the needs for working capital arise. From the Financial management point of view, the

nature of fixed assets and current assets differ from each other

1. The fixed assets are required to be retained in the business over a period of time and they

yield the returns over their life, whereas the current assets loose their identity over a short

period of time, say one year.

2. In the case of current assets, it is always necessary to strike a proper balance between the

liquidity and profitability principles, which is not the case with fixed assets. E.g. If the size

of current assets is large, it is always beneficial from the liquidity point of view as it

ensures smooth and fluent business operations. Sufficient raw material is always available

to cater to the production needs, sufficient finished goods are available to cater to any kind

of demand of customers, liberal credit period can be offered to the customers to improve

the sales and sufficient cash is available to pay off the creditors and so on.

However, if the investment in current assets is more than what is ideally required, it affects

the profitability, as it may not be able to yield sufficient rate of return on investment. On

the other hand, if the size of current assets is too small, it always involves the risk of

frequent stock out, inability of the company to pay its dues in time etc. As such, the

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investment in current assets should be optimum. Hence, it is necessary to manage the

individual components of current assets in a proper way. Thus, working capital

management refers to proper administration of all aspects of current assets and current

liabilities. Working Capital Management is concerned with the problems arising out of the

attempts to manage current assets, current liabilities and inter-relationship between them.

The intention is not to maximize the investment in working capital nor is it to minimize the

same. The intention is to have optimum investment in working capital. In other words, it

can be said that the aim of working capital management is to have minimum investment in

working capital without affecting the regular and smooth flow of operations. The level of

current assets to be maintained should be sufficient enough to cover its current liabilities

with a reasonable margin of safety. Moreover, the various sources available for financing

working capital requirements should be properly managed to ensure that they are obtained

and utilized in the best possible manner.

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FACTORS AFFECTING WORKING CAPITAL MANAGEMENT

The amount of working capital required depends upon a number of factors which can be

stated as below

Nature of Business:

Some businesses are such, due to their very nature, that their requirement of fixed capital is

more rather than working capital. These businesses sell services and not the commodities

and not the commodities and that too on cash basis. As such, no funds are blocked in piling

inventories and also no funds are blocked in receivables. E.g. Public utility services like

railways, electricity boards, infrastructure oriented projects etc. Their requirement of

working capital is less. On the other hand, there are some business like trading activity,

where the requirement of fixed capital is less but more money is blocked in inventories and

debtors. Their requirement of the working capital is more.

Length of Production Cycle:

In some business like machine tool industry, the time gap between the acquisitions of raw

material till the end of final production of finished product itself is quite high. As such

more amounts may be blocked either in raw materials, or work in progress or finished

goods or even in debtors. Naturally, their needs of working capital are higher. On the other

hand, if the production cycle is shorter, the requirement of working capital is also less.

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Size and Growth of Business:

In very small companies the working capital requirements are quite high overheads, higher

buying and selling costs etc. As such, the medium sized companies positively have an edge

over the small companies. But if the business starts growing after a certain limit, the

working capital requirements may be adversely affected by the increasing size.

Business ITrade Cycles:

If the company is operating in the period of boom, the working capital requirements may

be more as the company may like to buy more raw material, may increase the production

and sales to take the benefits of favourable markets, due to the increased sales, there may

be more and more amount of funds blocked in stock and debtors etc. Similarly, in case of

depression also, the working capital requirements may be high as the sales in terms of

value and quantity may be reducing, there may be unnecessary piling up of stocks without

getting sold, the receivables may not be recovered in time etc.

Terms of Purchase and Sales:

Sometimes, due to competition or custom, it may be necessary forthe company to extend

more and more credit to the customers, as a result of which more and more amounts is

locked up in debtors or bills receivables which increase working capital requirements. On

the other hand, in case of purchases, if credit is offered by the suppliers of goods and

services, a part of working capital requirement may be financed by them, but if it is

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necessary to purchase these goods or services on cash basis, the working capital

requirement will be higher.

Profitability:

The profitability of the business may vary in each and every individual case, which in its

turn may depend upon numerous factors. But high profitability will positively reduce the

strain on working capital requirements of the company, because the profits to the extent

that they are earned in cash may be used to meet the working capital requirements of the

company. However, profitability has to be considered from one more angles so that it can

be considered as one of the ways in which strain on working capital requirements of the

company may be relieved. And these angles are:

Taxation Policy:

How much is required to be paid by the company towards its tax liability?

Dividend Policy:

How much of the profits earned by the company are distributed by way of dividend?

Effect of Inflation on Working Capital Requirement:

The phase of inflation can be identified with the situation of increasing price levels,

increasing demand and increasing supply. As such, the working capital requirements

multiply during the phase of inflation due to increasing cost of production and increasing

level of sales turnover. However, in order to control the increasing demand for working

capital during the period of inflation, the following measures may be applied.

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Possibility of using cheaper substitute raw material, without affecting the quality, should be

explored. For this purpose, research activities may be conducted. Attempts should be made

to reduce the production costs to maximum possible extent. For this purpose, the

techniques like time and motion study, incentive schemes, cost reduction programmes etc.

may be implemented. Attempts should be made to reduce the operating cycle to the

maximum possible extent. Aiming at greater turnover at short intervals will go a long way

to reduce the stress on working capital requirements. Attempts should be made to reduce

the locked up working capital in non-moving or obsolete inventories. A clear-cut policy

should be formulated and followed for timely disposal of non- moving and obsolete

inventories. Similarly, efficient management information system should be developed to

reflect the position of inventory from the various angles. Attempts should be made to

reduce the amount looked up in receivables. Quicker realization of debts will go a long way

to reduce the stress on working capital requirements. Attempts should be made to make the

payments of to creditors in time. This helps the business to build up good reputation and

increases its bargaining power with respect to period of credit of credit for payment and

other conditions.

Attempts should be made to match the projected cash inflows and projected cash outflows.

If they do not match, some of the payments should be postponed or purchases of certain

avoidable items should be deferred. Estimation of Working Capital Requirements: First of

all estimates of all current assets should be made. These current assets may include stock,

debtors. Cash/Bank balance prepaid expenses etc.

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Difference between the estimated current assets and current liabilities will represent the

working capital requirements. To this sometime a standard percentage may be added to

take care of the contingencies. This technique is known as Cash Cost technique of

estimating of working capital requirements. There is another technique available for

estimating working capital requirements also and that is in the form of Balance Sheet

Method. In this the forecast is made of various assets and liabilities, the difference between

assets and liabilities indicating either the surplus or deficiency of cash. There are various

methods available for financing the working capital requirements:

Flied or Permanent or Core Working Capital:

This indicates the amount of minimum working capital, which is required to be maintained

by every business at any point of time, in order to carry on the business on permanent and

uninterrupted basis.

Variable or Temporary Working Capital:

This indicates that amount of working capital required by the business which is over and

above fixed or permanent or core working capital. This need of the working capital may

vary depending upon the fluctuations in demand as a result of changes in production or

sales.

As far as financing of the fixed or permanent needs of working capital are concerned, these

needs should be met out of the long term sources of funds, Own generation of funds, out of

the profits earned, shares or debentures.

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As far as financing of the variable or temporary needs of working capital are concerned,

these needs can be met from the various sources:

1. A part of these needs may be financed by way of the credits available from the suppliers

of material or services and of delayed payment of expenses.

2. A part of these needs may be financed by way of long term sources of funds in the form

of own generation of funds, out of profits earned shares, debentures and other long term

borrowings, public deposits etc.

3. A part of these needs may be financed by way of long term sources of funds in the form

of own generation of funds, out of profits earned, shares, debentures and other long term

borrowing.

4. A major portion of these working capital needs are financed by the Banks. In financing

the working capital needs of the business, the credit obtained from Banks plays a very

important role.

Bank Credit as a Source of Meeting Working Capital Requirements:

While bank credit is considered as a major source of meeting the working capital

requirement of the industry, the banks have to consider the following factors before

meeting their requirements.

A].What should be the amount of working capital assistance?

B].What should be the form in which working capital assistance may be extended?

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C].What should be the security that should be obtained for extending the working capital

assistance?

Amount of Assistance:

To obtain the bank credit for meeting the working capital requirements, the company will

be required to estimate the working capital requirements and will be required to approach

the banks along with the necessary supporting data. On the basis of the estimates submitted

by the company, the bank may decide the amount of assistance which may be extended,

after considering the margin requirements. This margin is to provide the cushion against

the reduction in the value of security. If the company fails to fulfill its obligations, the bank

may be required to realize the security for recovering the dues. Margin money is meant to

take care of the possible reduction in the value of security. The percentage of margin

money may depend upon the credit standing of the company, fluctuations in the price of

security or the directives of Reserve Bank of India from time to time.

Form of Assistance:

After deciding the amount of overall assistance to be extended to the company, the bank

can disburse the amount in any of the following forms

Non-Fund Based Lending

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Fund Based Lending

Non-Fund Based Lending

In case of Non-Fund Based Lending, the lending bank does not commit any physical

outflow of funds. As such, the funds position of the lending bank remains intact. The Non-

Fund Based Lending can be made by the banks in two forms-

a. Bank Guarantee:

Suppose Company A is the selling company and Company B is the purchasing company.

Company A does not know Company B and as such is concerned whether Company B will

make the payment or not. In such circumstances, D who is the Bank of Company B, opens

the Bank Guarantee in favour of Company A in which it undertakes to make the payment

to Company A if Company B fails to honour its commitment to make the payment in

future. As such, interests of Company A are protected as it is assured to get the payment,

either from Company B or from its Bank D. As such, Bank Guarantee is the mode which

will be found typically in the sellers market. As far as Bank D is concerned, while issuing

the guarantee in favour of Company A, it does not commit any outflow of funds. As such,

it is a Non-Fund Based Lending for Bank D. If on due date, Bank D is required to make the

payment to Company A due to failure on account of Company B to make the payment, this

Non-Fund Based Lending becomes the Fund Based Lending for Bank D which can be

recovered by Bank D from Company B. For issuing the Bank Guarantee, Bank D charges

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the Bank Guarantee Commission from Company B which gets decided on the basis of two

factors-what is the amount of Bank Guarantee and what is the period of validity of Bank

Guarantee. In case of this conventional for of Bank Guarantee, both company A as well as

Company B get benefited as it is able to make the credit purchases from Company A

without knowing Company A. As such, Bank Guarantee transactions will be applicable in

case of credit transactions.

In some cases, interests of purchasing company are also to be protected. Suppose that

Company A which manufactures capital goods takes some advance from the purchasing

Company B. If Company A fails to fulfill its part of contract to supply the capital goods to

Company B, their needs to be to be some protection available to Company B. In such

circumstances, Bank C which is the banker of Company A opens a Bank Guarantee in

Favour of Company B in which it undertakes that if Company A fails to fulfill its part of

the contract, it will reimburse any losses incurred by Company B due to this non fulfillment

of contractual obligations. Such Bank Guarantee is technically referred to as performance

Bank Guarantee and it ideally found in the buyers market.

b. Letter of Credit:

The non-fund based lending in the form of letter of credit is very regularly found in the

international trade. In case the exporter and the importer are unknown to each other. Under

these circumstances, exporter is worried about getting the payment from the importer and

importer is worried as to whether he will get the goods or not. In this case, the importer

applies to his bank in his country to open a letter of credit in favour of the exporter

whereby the importers bank undertakes to pay the exporter or accept the bills or drafts

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drawn by the exporter on the exporter fulfilling the terms and conditions specified in the

letter of credit.

Fund Based Lending

In case of Fund Based Lending, the lending bank commits the physical outflow of funds.

As such, the funds position of the lending bank gets affected. The Fund Based Lending can

be made by the banks in the following forms-

Loan:-

In this case, the entire amount of assistance is disbursed at one time only, either in cash or

by transfer to the companys account. It is a single advance. The loan may be repaid in

instalments, the interests will be charged on outstanding balance.

Overdraft: - In this case, the company is allowed to withdraw in excess of the balance

standing in its Bank account. However, a fixed limit is stipulated by the Bank beyond

which the company will not be able to overdraw the account. Legally, overdraft is a

demand assistance given by the bank i.e. bank can ask for the repayment at any point of

time. However in practice, it is in the form of continuous types of assistance due to annual

renewal of the limit. Interest is payable on the actual amount drawn and is calculated on

daily product basis.

Cash Credit:-

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In practice, the operations in cash credit facility are similar to those of overdraft facility

except the fact that the company need not have a formal current account. Here also a fixed

limit is stipulated beyond which the company is not able to withdraw the amount. Legally,

cash credit is a demand facility, but in practice, it is on continuous basis. The interests is

payable on actual amount drawn and is calculated on daily product basis.

Bills purchased or discounted:-

This form of assistance is comparatively of recent origin. This facility enables the company

to get the immediate payment against the credit bills raised by the company. The bank

holds the bill as a security till the payment is made by the customer. The entire amount of

bill is not paid to the company. The Company gets only the present worth of the amount of

bill, the difference between the face value of the bill and the amount of assistance being in

the form of discount charges. On maturity, bank collects the full amount of bill from the

customer. While granting this facility to the company, the bank inevitably satisfies itself

about the credit worthiness of the customer. A fixed limit is stipulated in case of the

company, beyond which the bills are not purchased or discounted by the bank.

Working Capital Term Loans: -

Tomeet the working capital needs of the company, banks may grant the working capital

term loans for a period of 3 to 7 years, payable in yearly or half yearly installments.

Packing Credit: -

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This type of assistance may be considered by the bank to take care of specific needs of the

company when it receives some export order. Packing credit is a facility given by the bank

to enable the company to buy the goods to be exported. If the company holds a confirmed

export order placed by the overseas buyer or a letter of credit in its favour, it can approach

the bank for packing credit facility.

Operating cycle:

The time between purchase of inventory items (raw material or merchandise) and

their conversion into cash is known as operating cycle or working capital cycle. The longer

the period of conversion the longer will be the period of operating cycle. A standard

operating cycle may be for any time period but does not generally exceed a financial year.

Obviously, the shorter the operating cycle larger will be the turnover of the fund invested

for various purposes. The channels of investment are called current assets.

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OPERATING CYCLE

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Cash

Receipt fromdebtors

Creation ofreceivables

(Debtors)

Sales of

FinishedGoods

Creation ofA/c payable

(Creditors)

Purchase of

raw material,components

Warehousing

of FinishedGoods

Manufacturingoperation: wages &

salaries, fuel,

power, etc

Office, selling,distribution and

other expenses

Payments to

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WORKING CAPITAL FINANCE

A manufacturing concern needs finance not only for acquisition of fixed assets but

also for its day-to-day operations. It has to obtain raw materials for processing, pay wage

bills & other manufacturing expenses, store finished goods for marketing & grant credit to

the customers. It may have to pass through the following stages to complete its operating

cycle-

i. Conversion of cash into raw materials raw material procured on credit, cash may

have to be paid after a certain period.

ii. Conversion of raw materials into stock in process.

iii. Conversion of stock in process into finished goods.

iv. Conversion of finished goods into receivables/debtors or cash.

v. Conversion of receivables/debtors into cash.

A non-manufacturing trading concern may not require raw material for their

processing, but it also needs finance for storing goods & providing credit to its customers.

Similarly a concern engaged in providing services, it may not have to keep inventories but

it may have to provide credit facility to its customers. Thus all enterprises engaged in

manufacturing or trading or providing services require finance for their day-to-day

operations, the amount required to finance day-to-day operation is called working capital &

the assets & liabilities are created during the operating cycle are called current assets &

current liabilities. The total of all the current assets is called gross working capital & the

excess of current assets over current liabilities is called net working capital.

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When entrepreneurs for financing working capital requirements approach the

banks, the bank has to examine the viability of the project before agreeing to provide

working capital for it. Financial institutions & bank while providing term loan finance to

unit for acquisition of fixed assets does a detailed viability study. They have to ensure that

the project will generate sufficient return on the resources invested in it. The viability of a

project depends on technical feasibility, marketability of the products, at a profitable price,

availability of financial resources in time & proper management of the unit. In brief the

project should satisfy the tests of technical, commercial, financial & managerial feasibility.

Proper co-ordination amongst banks & financial institution is necessary to judge the

viability of a project & to provide working capital at appropriate time without any delay. If

a unit approaches banks only for working capital requirement & no viability study has been

done earlier which is done at the time of providing term loans, a detailed viability study is

necessary before agreeing to provide working capital finance.

In the view of scarcity of bank credit, its increasing demand from various sectors of

economy & its importance in the development of economy, bank should provide working

capital finance according to production requirements. Therefore it is necessary to make a

proper assessment of total requirement of the working capital, which depends on the nature

of the activities of an enterprise & the duration of its operating cycle. It has to be ensured

that the unit will have regular supply of raw material to facilitate uninterrupted production.

The unit should be able to maintain adequate stock of finished goods for smooth sales

operation. The requirement of trade credit, facilities to be given by the unit to its customers

should also be assessed on the basis of practice prevailing in the particular industry/trade

which assessing above requirements, it should also be ensured that carrying cost of

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inventories & duration of credit to customers are minimized. After assessing the total

requirement of working capital, a part of working capital requirement should be financed

for the long term & partly by determining maximum permissible bank finance.

ASSESSMENT OF WORKING CAPITAL

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A unit needs working capital funds mainly to carry current assets required for its

operations. Proper assessment of funds required for working capital is essential not only in

the interest of the concerned unit but also in the national interest to use the scare credit

according to production requirements. Inadequate levels of working capital may result in

under-utilization of capacity and serious financial difficulties. Similarly excessive levels

may lead to unproductive use of credit and unnecessary interest Burdon on the unit. Proper

assessment of working capital requirement may be done as under-

I. Norms for inventory and receivables:

If the bank credit is to be linked with production requirements, it is necessary to assess

the requirements on the basis of certain norms. The study group to frame guidelines to

follow-up of bank credit (Tandon Study Group) appointed by Reserve Bank of India had

suggested the norms for inventory and receivables regarding 1: major industries on the

basis of company finance studies made by Reserve Bank process periods in the different

industries, discussions with the industry experts and feed-back received on the interim

report. The norms suggested by Tandon Study Group are being reviewed from time to

time by the Committee of Direction constituted by the Reserve Bank to keep a constant

view on working capital requirements. The committee has representatives from a few

banks and it generally once in a quarter. It also consults the representatives from industry

and trade. It keeps a watch on the various issues relating to working capital requirements

and gives various suggestions to suit the changing requirements of the industry and trade.

Banks make their own assessment of credit requirements of borrowers based on a total

study of borrowers business operations and they can also decide the levels of holding

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each item of inventory as also of receivables which in their view would represent a

reasonable built up of current assets for being supported by banks finance. Banks may

also consider suitable internal guidelines for accepting the projections made by the

borrowers regarding sundry creditors as sundry creditors are taken as a source of

financing current assets (inventories, receivables, etc.), it is necessary to project them

correctly while calculating need of bank finance for working capital requirements.

II. Computation of Maximum Permissible Bank Finance (MPBF):

The Tandon Study group had suggested the following alternatives for working out the

maximum permissible bank finance:-

a. Bank can work out the working capital gap. i. e. total current assets less current

liabilities other than bank borrowings and finance a maximum of 75 per cent of

the gap; the balance to come out of long-term funds, i.e. owned funds and term

borrowings

b. Borrower should provide for a minimum of 25 per cent of total current assets out

of long-term funds, i.e. owned funds and long term borrowings. A certain level of

credit for purchases and other current liabilities inclusive of bank borrowings will

not exceed 75 per cent of current assets.

It may be observed from the above that borrowers contribution from long term funds

would be 25 per cent of the working capital gap under the first method of lending and 25

per cent of total current assets under the second method of lending. The above minimum

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contribution of long-term funds is called minimum stipulated Net Working Capital (NWC)

which comes from owned funds and term borrowings.

Above two method of lending may be illustrated by taking the following example of a

borrowers financial position, projected as at the end of next year.

Current Liabilities Amt Current Assets Amt

Creditors for purchase 200 Raw materials 380

Other current liabilities 100 Stock in process 40

300 Finished goods 180

Bank borrowing, including bills

discounted with bankers

400 Receivables, including bills

discounted with bankers

110

Other current assets 30

700 740

First method Second method

Total current assets 740 total current assets 740

Less: current liabilities 25% of above from long term

Other than bank borrowings 300 sources 185

Working capital gap 440 55525% of above from long term less: current liabilities

Sources 110 Other than bank borrowings 300

Maximum permissible bank 330 Maximum permissible bank 255

Finance finance

Excess Bank borrowings 70 Excess Bank borrowings 145

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Current ratio 1.17:1 Current ratio 1.33:1

It may be observed from the above that in the first method, the borrower has to

provide a minimum of 25 per cent of working capital gap from ling-term funds and it gives

a minimum current ratio 1.17:1. In the second method, the borrower has to provide a

minimum of 25 per cent of total current assets from long-term funds and gives a minimum

current ratio of 1.33:1.

While estimating the total requirement of long-term funds for new projects,

financial institutions/banks should calculate for working capital on the basis of norms

prescribed for inventory and receivables and by applying the second method of lending. A

project may suffer from shortage of working capital funds if sufficient margin for working

capital is not provided as per the second method of lending while funding new projects.

Proper co-ordination between banks & financial institutions is necessary to ensure

availability of sufficient working capital finance to meet the production requirement.

III. Classification of current assets & Current liabilities:

In order to calculate net working capital & maximum permissible bank finance, it is

necessary to have proper classification of various items of current assets & current

liabilities. All illustrative lists of current assets & current liabilities for the purpose of

assessment of working capital are furnished below;

Current assets: -

a. Cash and bank balances

b. Investments

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c. Receivables arising out of sales other than deferred receivables (including bills

purchased & discounted by bankers)

d. Installments by deferred receivables due within one year

e. Raw materials & components used in the process of manufactured including

those in transit

f. Stock in process including semi finished goods

g. Finished goods including goods in transit

h. Other consumable spares

i. Advance payment for tax

j. Prepaid expenses

k. Advances for purchases of raw materials, components & consumable stores

l. Payment to be received from contracted sale of fixed assets during the next 12

months

Current Liabilities:

a. Short-term borrowings (including bills purchased & discounted) from

Banks and ii. Others

b. Unsecured loans

c. Public deposits maturing within one year

d. Sundry creditors (trade) for raw material & consumer stores & spares

e. Interest & other charges accrued but no due for payments

f. Advances/progress payments from customers

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g. Deposits from dealers selling agents, etc.

h. Statutory liabilities

Provident fund dues

Provision for taxation

Sales-tax, excise, etc.

Obligation towards workers considered as statutory

i. Miscellaneous current liabilities

Dividends

Liabilities for expenses

Gratuity payable within one year

Any other payments due within one year

Notes on classification of Current Assets & Current Liabilities:

1. Investment in shares, debenture, etc. and advances to other firms/companies, not

connected with the business of the borrowing firm, should be excluded from current

assets. Similarly investment made in units of Unit Trust of India & other mutual

funds & in associate companies/subsidiaries, as well as investment made and/or

loans extended as inter-corporate deposits should not be included in the build-up of

current assets while assessing maximum permissible bank finance.

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2. The borrowers are not expected to make the required contribution of 25 per cent

from long-term sources in respect of export receivables. Therefore, export

receivables may be included in the total current assets for arriving at the maximum

permissible bank finance but the minimum stipulated net working capital may be

reckoned after excluding the quantum of export receivables from the total current

assets.

3. Dead inventory i.e. slow moving or obsolete items should not be classified as

current assets.

4. Security deposits/tender deposits given by borrower should be classified as non-

current assets irrespective of whether they mature within the normal operating cycle

of one year or not.

5. Advances/progress payments from customer should be classified as current

liabilities. However, where a part of advances received is required by government

regulations to be invested in certain approved securities, the benefit of netting may

be allowed to the extent of such investment and the balance may be classified as

current liability.

6. Deposits from dealers, selling agents, etc. received by the borrower may treated as

term liabilities irrespective of their tenure if such deposits are accepted to be

repayable only when the dealership/agency is terminated. The deposits, which do

not fulfill the above condition, should be classified as current liabilities.

7. Disputed liabilities in respect of income tax, excise, custom duty and electricity

charges need not be treated as current liabilities except to the extent of provided for

in the books of the borrower. Where such disputed liabilities are treated as

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contingent liabilities for period beyond one year, the borrower should be advised to

make adequate provision so that he may be in a position to meet the liabilities as &

when they accrue.

8. If disputed excise liability has been shown as contingent liability or by way of notes

to the balance sheet, it need not be treated as current liability for calculating the

permissible bank finance unless it has been collected or provided for in the

accounts of borrowers. A certificate from the Statutory Auditors of the borrowers

may be obtained regarding the amount collected from the customers in respect of

disputed excise liability or provision made in the borrowers accounts. The amount

of excise duty payable should be treated as current liability for the purpose of

working out the permissible limit of the bank finance strictly on the basis of the

certificate from the borrowers Statutory Auditors. The same principle may also be

applied for disputed sales tax dues.

9. In case of other statutory dues, dividends, etc., estimated amount payable within

one year should be shown as current liabilities even if specific provisions have not

been made for their payment.

10. As per the instructions issued by the Reserve Bank in October, 1993, the entire term

loan investment falling due for payment in the next twelve months need not be

treated as an item of current liabilities for the purpose of arriving at MPBF.

However all overdue term loan should be treated as current liabilities unless the

loan has been rescheduled by the financial institutions/banks. It may be added that

the entire amount of term loan installments payable within the next twelve months

which is kept outside the current liabilities while calculating MPBF. Need not be

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taken into account while computing net working capital (NWC). However the

entire amount of term loan installments due within the next twelve months should

continue to be treated as current liability for the purpose of calculating the current

ratio.

IV. Information/Data required for assessment of working capital:

In order to assess the requirements of working capital on the basis of production needs, it

is necessary to get the data from the borrowers regarding their past/projected production,

sales, cost of production, cost of sales, operating profit, etc. in order to ascertain the

financial position of the borrowers & the amount of working capital needs to be financed

by banks, it is necessary to call for the data from the borrowers regarding their net worth,

long term liabilities, current liabilities, fixed assets, current assets, etc. the Reserve Bank

prescribed the forms in 1975 to submit the necessary details regarding the assessment of

working capital under its credit authorization scheme. The scheme of credit authorization

was changed into credit monitoring arrangement in 1988. The forms used under the credit

authorization scheme for submitting necessary information have also been simplified in

1991 for reporting the credit sanctioned by banks above the cut-off point to reserve bank

under its scheme of credit monitoring arrangement.

As the traders and merchant exporters who do not have manufacturing activities are

not required to submit the data regarding raw materials, consumable stores, goods-in-

process, power and fuel, etc., a separate set of forms has been designed for traders and

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merchant exporters. In view of the peculiar nature of leasing and the hire purchase

concerns, a separate set of forms has also designed for them.

In addition to the information/data in the prescribed forms, bank may also call for

additional information required by them depending on the nature of the borrowers

activities & their financial position. The data is collected from the borrowers in the

following six forms: -

1. Particulars of the existing/proposed limits from the banking system (form I)

Particulars of the existing credit from the entire banking system as also the term

loan facilities availed of from the term lending institutions/banks are furnished in this

form. Maximum & minimum utilization of the limits during the last 12 months

outstanding balances as on a recent date are also given so that a comparison can be

made with the limits now requested & the limits actually utilized during the last 12

months.

2. Operating Statement (Form II)

The data relating to last sales, net sales, cost of raw material, power & fuel, direct

labour, depreciation, selling, general expenses, interest, etc. are furnished in this form.

It also covers information on operating profit & net profit after deducting total

expenditure from total sale proceeds.

3. Analysis of Balance Sheet (Form III)

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A complete analysis various items of last years balance sheet, current years

estimate & following years projections is given, in this form. The details of current

liabilities, term liabilities, net worth, current assets, other non-current assets, etc. are

given in this form as per the classification accepted by banks.

4. Comparative statement of current assets & current liabilities (Form IV)

This form gives the details of various items of current assets and current liabilities

as per classification accepted by banks. The figures given in this form should tally with

the figures given in the form III where details of all the liabilities & assets are given. In

case of inventory, receivables and sundry creditors; the holding/levels are given not

only in absolute amount but also in terms of number of month so that a comparative

study may be done with prescribed norms/past trends. They are indicated in terms of

numbers of months in bracket below their amounts.

5. Computation of Maximum Permissible Bank Finance (Form V)

On the basis of details of current assets & liabilities given in form IV, Maximum

Permissible Bank Finance is calculated in this form to find out credit limits to be

allowed to the borrowers.

6. Fund Flow Statement (Form VI)

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In this form, fund flow of long term sources & uses is given to indicate whether

long term funds are sufficient for meeting the long term requirements. In addition to

long term sources and uses, increase/decrease in current assets is also indicated in this

form.

V. Check list for verification of the information/data:

Bank should verify not only the arithmetical accuracy of the data furnished by the

borrowers but also the logic behind various assumptions based on which the projections

have been made. For this purpose, bank officials should hold discussions with the

borrowers on projected sales, level of operations, level of inventory, receivables, etc. if

necessary, a visit to the factory may also be made to have a clear idea of products and

processes.

ASSESSEMENT OF OTHER LIMITS

LETTER OF CREDIT

The banker examines the proposal of the letter of credit from two angles:

o The cases where letter of credit is required once only

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o The cases where letter of credit is required once regularly.

In the second category it is convenient for the banker to fix the separate limit of the letter of

credit.

ASSESSEMENT OF THE LIMITS UNDER LETTER OF CREDIT-WITH LEAD

TIME

The buyer does not receive the goods immediately on the placement of the order on the

seller. There is always long time log between the order placement and the receipt of the

material. This period is also referred to as the lead-time.

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Example: -

If it is assumed that the total raw material requirement is Rs.240lacs per annum and the

normal lead time is 2 months, the buyer will be required to place order so that he has at

least 2 months stock(ignoring safely level). Thus, the total number of order placed would

be 6 per year and the value of per order would be Rs.40 Lacs. This is shown below

Assessment of the limits under LC- with lead-time

Annual requirement of raw material 240 Lacs

Normal lead time 2 months

Value per order (A) 240/6=Rs.40 Lacs

Margin for customer @20%(B) Rs 8 Lacs

Limits under letter of credit (A-B) Rs 32 Lacs

Assessment of the limits under letter of credit-without lead-time

Annual requirement of raw material 240 lacs

Monthly requirement of raw material 240/12 months =20 lacs

Normal inventory level (1 month) Rs 20 lacs

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Value per order (A) Rs 20 lacs

Margin for customer @ 20% (B) Rs 4 lacs

Limits under letter of credit (A-B) Rs 16 lacs

BANK GUARANTEES

There is no standard formula for assessment of bank guarantee limit. The details pertaining

to nature of guarantees, particulars of the contract, period for which the guarantee is sought

and the amount of guarantee to be obtained, this information along with the view on the

creditworthiness of the borrower and relationship with the bank comprise the major input

towards deciding the sanction of limits required by borrower. Appropriate conditions

regarding cash margin and securities have to be laid down to protect the interest of the

bank..

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PROCEDURE FOR WORKING CAPITAL FINANCE

CREDIT SANCTION PROCESS

The revised credit process is introduced with a view of reducing the time lag in the sanction

of credit besides clearly delineating the areas of responsibilities of various functionaries.

As per this the revised process is divide into two components that is Pre sanctioning and

Post sanctioning

In the pre sanctioning it is the only time that the bank can take due assessment and

precautions to make sure that the investments are done for the benefit of the bank. The post

sanctioning is the follow of the payment. Incase the payment defaults then the account will

go into NPA in stages and the bank is then said to scrutinize the said account.

PRE SANCTION PROCESS: -

Obtain loan application

When a customer required loan he is required to complete application form and submit the

same to the bank also the borrower has to be submit the required information along with

the application form.

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The information, which is generally required to be submitted by the borrower along with

the loan application, is under: -

Audited balance sheets and profit and loss accounts for the previous three year(in

case borrower already in the business)

Estimated balance sheet for current year.

Projected balance sheet for next year.

Profile for promoters/directors, senior management personnel of the company.

In case the amount of loan required by borrower is 50 lacs and above he should be

submit the CMA Report

46

PRE SANCTION

PROCESS

APPRAISAL &

RECOMMANDATION

ASSESSMENT

SANCTIONING


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Examine for preliminary appraisal

RBI guidelines. Policies

Prudential exposure norms and bank lending policy

Industry exposure restriction and related risk factors.

Compliance regarding transfer of borrowers accounts from one bank to

another bank

Government regulation / legislation impact on the industry

Acceptability of the promoter and applicant status with regards to other unit

to industries.

Arrive at the preliminary decision.

Examine/analysis /assessment

Financial statement (in the prescribed forms) refers figure WC cycle & BS

assessment thumb rules.

Financial ratio & Dividend policy.

Depreciation method

Revaluation of fixed assets.

Records of defaults (Tax, dues etc.)

Pending suits having financial implication (Customs, excise etc.)

Qualifications to balance sheet auditors remarks etc.

Trend in sales and profitability and estimates /projection of sales.

Production capacities and utilization: past & projected production efficiency

and cost.

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Estimated working capital gap W.R.T acceptable buildup of

inventory/receivables/other current assets and bank borrowing patterns.

Assess MPBF determine facilities required

Assess requirement of off balance sheet facilities viz.L/cs,B/gs etc.

Management quality, competence, track records

Companys structure and system

Market shares of the units under comparison.

Unique feature

Profitability factors

Inventory/Receivable level

Capacity utilization

Capital market perception.

POST SANCTION PROCESS

Supervision and follow up: -

Sanction credit limit of working capital requirement after proper assessment of proposal is

alone not sufficient. Close supervision and follow up are equally essential for safety of

bank credit and to ensure utilization of fund lend. A timely action is possible only close

supervision and followed up by using following techniques.

o Monthly stock statement

o Inspection of stock

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o Scrutiny of operation in the account

o Quarterly/half quarterly statements.

o Under information system

o Annual audited report

49

POST SANCTION

PROCESS

FOLLOW UP

SUPERVISION

MONITORING& CONTROL


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CREDIT MONITORING ARRANGEMENT

Consequent upon the withdrawal of requirement of prior authorization under the erstwhile

credit authorization scheme (CAS) and introduction of a system of post sanction scrutiny

under credit monitoring arrangement (CMA) the database forms have been recognized as

CMA database. The revised forms for CMA database as drawn up by the sub-committee of

committee of directions have come into use from 1st April 1991.

The existing forms prescribed for specified industries continue to remain in force. With a

view to imparting uniformity to the appraisal system, database from all borrowers

including SSI units enjoying working capital limits of Rs. 50 lacs and more from the

banking system should be obtained.

The revised sets of forms have been separately prescribed for industrial borrowers and

traders/merchant exporters. The details of forms are as under: -

Form 1: - particulars of the existing/proposed limit from the banking system.

Form 2: -Operating statement.

It contains data relating to gross sales, net sales, cost of raw material, power and fuel, etc. It

gives the operating profit and the net profit figures.

Form 3 : - Analysis of balance sheet.

It is complete analysis of various items of last years balance sheet; current years estimate

and following years projection are given in this form.

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Form 4 : - Comparative statement of current asset and liabilities.

Details of various items of current asset and current liabilities are given.

The figures in this form must tally with those in form III.

Form 5: - Computation of maximum permissible bank finance for working capital.

The calculation of MPBF is done in this form to obtain the fund based credit limits to be

granted to the borrower.

Form 6: - Fund flow statement

It provides the details of fund flow from long term sources and uses to indicate weather

they are sufficient to meet the borrowers long term requirements.

CREDIT RATING MODEL

The various risk faced by any company may be broadly classified as follows:

Industry Risk: It covers the industry characteristic, compensation, financial data etc.

Company/ business risk: It considers the market position, operating efficiency of the

company etc.

Project risk: It includes the project cost, project implementation risk, post project

implementation etc.

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Management risk: It covers the track record of the company, their attitude towards risk,

propensity for group transaction, corporate governance etc.

Financial risk: financial risk includes the quality of financial statements, ability of the

company to raise capital, cash flow adequacy etc.

DRAWING POWER OF THE BORROWER

The drawing power that a borrower enjoys at any one point depends on each components

of working capital. The bank for each component, which the borrower must hold as his

contribution to finance working capital, prescribes margins. The drawing power of the

borrower can be best explained with the following illustration

Illustration:

Suppose a borrower has Rs 100.00 lacs as working capital limit sanctioned to him by a

bank.

The security provided by the borrower to the bank is the hypothecation of inventory.

Suppose, the borrower needs to hold an inventory level of say 130 lacs in order to enjoy Rs

100 lacs as his working capital limit.

The actual level of inventory with the borrower at a point is say 110 lacs.

The inventory margin prescribed by the bank is say 25 %

Therefore with this inventory level, the borrower enjoys only Rs 82.5 lacs as his working

capital limit as against Rs 100 lacs.

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Inventory level (Required) Rs 130 lacs

Drawing power of borrower Rs 100 lacs

Inventory level (Actual) Rs 110 lacs

Margin prescribed by bank 25 %

Drawing power of borrower 110-(0.25 110) = Rs 82.5 lacs

Suppose, the borrower holds Rs 150 lacs of inventory,

Inventory level (required) Rs 150 lacs

Drawing power of borrower Rs 100 lacs

Inventory level (actual) Rs 150 lacs

Margin prescribed by bank 25 %

Drawing power of borrower 150 (0.25 150) = Rs. 112.2 lacs

Therefore, in this case the borrower would still enjoy Rs 100 lacs as his working capital

limits as against Rs 112.5 lacs.

Therefore, the lower of the two is always considered as the working capital limit or the

drawing power of the borrower sanctioned by the bank.

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SECURITY

Banks need some security from the borrowers against the credit facilities extended to them

to avoid any kind of losses. securities can be created in various ways. Banks provide credit

on the basis of the following modes of security from the borrowers.

Hypothecation: under this mode of security, the banks provide credit to borrowers against

the security of movable property, usually inventory of goods. The goods hypothecated,

however, continue to be in possession of the owner of the goods i.e. the borrower. The

rights of the banks depend upon the terms of the contract between borrowers and the

lender. Although the bank does not have the physical possession of the goods, it has the

legal right to sell the goods to realize the outstanding loans.

Hypothecation facility is normally not available to new borrowers.

Mortgage: It is the transfer f a legal / equitable interest in specific immovable property for

securing the payment of debt. It is the conveyance of interest in the mortgaged property.

This interest terminated as soon as the debt is paid. Mortgages are taken as an additional

security for working capital credit by banks.

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Pledge: The goods which are offered as security, are transferred to the physical possession

of the lender. An essential prerequisite of pledge is that the goods are in the custody of the

bank. Pledge creates some kind of liability for the bank in the sense that Reasonable care

means care, which a prudent person would take to protect his property. In case of non-

payment by the borrower, the bank has the right to sell the goods.

Lien: The term lien refers to the right of a party to retained goods belonging to other party

until a debt due to him is paid. Lien can be of two types viz. Particular lien i.e. A right to

retain goods until a claim pertaining to these goods are fully paid, and General lien, Which

is applied till all dues of the claimant are paid. Banks usually enjoyed general lien.

BANKING ARRANGEMENTS

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Working capital is made available to the borrower under the following arrangements;

CONSORTIUM BANKING ARRANGEMENT:

RBI till 1997 made it obligatory for availing working capital facilities beyond a limit (Rs

500 million in 1997), through the consortium arrangement. The objective of the

arrangement was to jointly meet the financial requirement of big projects by banks and also

share the risks involved in it.

While it consortium arrangement is no longer obligatory, some borrowers continue to avail

working capital finance under this arrangement. The main features of this arrangement are

as follows;

Bank with maximum share of the working capital limits usually takes the role of lead

bank.

Lead bank, independently or in consultation with other banks, appraise the working capital

requirements of the company.

Banks at the consortium meeting agree on the ratio of sharing the assessed limits.

Lead bank undertakes the joint documentation on behalf of all member banks.

Lead bank organizes collection and dissemination of information regarding conduct of

account by borrower.

MULTIPLE BANKING ARRANGEMENT

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Multiple banking is an open arrangement in which no banks will take the lead role.

Most borrowers are shifting their banking arrangement to multiple banking arrangements.

The major features are

Borrower needs to approach multiple banks to tie up entire requirement of working capital.

Banks independently assessed the working capital requirements of the borrower.

Banks, independent of each other, do documentation, monitoring and conduct of the

account

Borrowers deals with all financing banks individually.

SYNDICATION

A syndicated credit is an agreement between two or more lenders to provide a borrower

credit facility using common loan agreement. It is internationally practiced model for

financing credit requirements, wherein banks are free to syndicate the credit limit

irrespective of quantum involved. It is similar to a consortium arrangement in terms of

dispersal of risk but consist of a fixed repayment period.

REGULATION OF BANK FINANCE

INTRODUCTION

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Bank follows certain norms in granting working capital finance to companies.

These norms have been greatly influenced by the reconditions of various committees

appointed by the RBI from time to time. The norms of working capital finance followed by

banks are mainly based on the recommendation of Tandon committee and chore

committee.

These committees were appointed on the presumption that the existing system of bank

lending of number of weakness industries in India have grown rapidly in the last three

decades as result of which, the industrial system has become vary complex. The banks role

has shifted from trade financing to industrial financing during this period.

However, the banks lending practices and styles have remained the same. Industries today

fail to use bank finance efficiently. Their techniques of managing funds are unscientific and

non-professional. The industries today lack in reducing costs, optimizing the use of inputs,

conserving resources etc.

The weakness of the existing system highlighted by the Dehejia committee in 1968 and

identified by the tondon committee in 1974, are as follows:

It is the borrower who decides how much he would borrow ;the bankers does not decide

how much he would lend and is, therefore, not in a position to do credit planning. The bank

credit is treated as the first sources of finance and not as supplementary to other sources of

finance.

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The amount of credit is extended is based on the amount of security available and not on

the level of operations of the borrower.

Security does not by itself ensure safety of bank. Funds since all bad sticky advances are

secure advances. Safety essentially lies in the efficient follow up of the industrial

operations of the borrower.

We discuss the following committees important finding and recommendations for bank

finance: -

TANDON COMMITTEE

CHORE COMMITTEE.

TANDON COMMITTEE

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INTRODUCTION:

The Tandon committee was appointed by the RBI in July 1974 and headed by Shri.

Prakash L. Tandon, the chairman of the Punjab national bank, to suggest guidelines for

rational allocation and optimum use of bank credit taking into consideration the weakness

of the leading system. Bank credit, which had become a scare commodity, strictly rationed

to meet the credit requirement of all the sectors. The larger sector of the industry needed

strict rationing becomes

It was over relying on bank finance and pre empted most of it while the other sectors were

not getting even their due share. Therefore, the method and criterion adopted for fixing

credit ration needed to be standardized so that there is minimum scope for miss-use or part

of the credit uses. The Tandon committee was concern exactly with this problem. Its report

laid down as to how the credit ratio of individual borrowers could be fixed at imposed

certain obligation on them for the efficient use of the credit made available.

The recommendation of the Tandon committeebased on the following notions:

The borrower should indicate the demand for credit for which he should draw operating

plans for the ensuring year and supply them to the banker. This would facilitate credit

planning at the banks level and help the banker in evaluating the borrowers credit needs in

a more realistic manner.

The banker should finance only the genuine production needs of the borrower. The

borrower maintained reasonable levels inventories and receivables. Efficient management

of resources should therefore be ensured to eliminate slow moving and flabby inventories.

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The working capital needs of borrower cannot entirely finance by the banker. The banker

will finance only a reasonable part of it for the remaining; the borrower should depend on

his own fund. Recommendation of Tandon committee accordingly, the Tandon committee

put forth in the following recommendations

Inventory and receivables norms

The borrower is allowed to hold only a reasonable level of current asset, particularly

inventory and receivable. The committee suggested the maximum level of raw material,

stock in process, finished goods, which corporate in an industry should be to hold.

Only the normal inventory based on a production plan, lead-time of supplies, economic

ordering levels and reasonable factor safety should be financed by the banker.

Lending norms:

The banker should finance only a part of the working capital gap; the other part should be

financed by the borrower form long-term sources.

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The current asset will be taken on the estimate values or values as per the Tandon

committee norms, whichever is lower.

The current will consist of inventory and receivables, referred as chargeable current assets

(CCA), and other current assets (OCA).

MAXIMUM PERMISSIBLE BANK FINANCE:

The Tandon committee suggested the following three methods of determining the

permissible level of bank borrowings-

The borrower will contribute 25 % of the working capital gap from long term fund i.e

owned fund and term borrowings; the remaining 75 % can be financed from bank

borrowings. This method gives a minimum current ratio of 1:1. This method was

considered suitable only for very small borrowers where the requirement 0 credit was less

than Rs 10 lacs

The borrower will contribute 25 % of the total current assets from long-term funds i.e.

owned funds and term borrowings. A certain level of credit for purchases and other current

liabilities will be available to fund the building up of current assets and the bank will

provide the balance. Consequently, the current liabilities inclusive of bank borrowing could

not exceed 75 % of current assets. This method gives a current ratio of1.3:1. This method

was considered for all borrowers whose credit requirements were more than Rs 10 lacs.

The borrower will contribute 100 % of core current assets, defined at the absolute

minimum level of raw material, processed stock, finished goods and stores, which are in

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the pipeline. A minimum level of the 25 % of the balance of the current assets should be

finance from the long term funds and term borrowings. This method covers straightness the

current ratio. The third is the ideal method. Borrowers in the second stage are not allowed

to revert to the first stage. This method applies to all borrowers having credit limit in

excess of Rs.20 lacs from the bank. However this method was not accepted for

implementation.

In some cases, the net working capital was negative or 25 % of the working capital gap.

The new systems allowed this deficiency to be financed in addition to the permissible bank

finance by the bank. This kind of credit facility is called working capital demand loan,

which was to be regulated over a period of time depending on the funds generating

capacity and ability of the borrower.

The working capital demand loan is not allowed to be raised in the subsequent year. For

additional credit in subsequent year, the borrowers long-term sources were required to

provide 25 % of the additional working capital gap.

4. Style of credit:

The committee recommended the bifurcation of total credit limit into fixed and fluctuating

parts.

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The fixed component is then treated as demand loan for the year representing minimum

level of borrowing, which the borrower expected to use through out the year.

The fluctuating component is taken care of by a demand cash credit. It could be partly used

by way of bills.

The new CC limit should be placed on a quarterly budgeting reporting system.

The interest rate on the loan components should be charged lower than the cash credit

amount. The RBI has stipulated the interest differentiate at 1 %.

The cash credit limits sanctioned (fluctuating) are currently 205 and the loan components

(fixed) are 80 %.

5) INFORMATION SYSTEM:

The committee advocated for grater flow of information from borrower to the bank for

operational purpose and for the purpose of supervision and flow of up credit.

Information should be provided in the following forms:

QUARTERLY INFORMATION SYSTEM: FORM:

It should contain the production and sales estimates for the current and next quarter. also,

the current asset current liabilities estimates for the next quarter should be mentioned.

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Quarterly information system: Form II:

It should contain the actual production and sales finger during the current year and the

latest completed year. Also, actual current asset and current liabilities for the latest

completed quarter should be mention.

Half year operating statement form IIIA:

Actual operating performance for the half year ended against the estimate should be

mentioned.

Half year fund flow statement: Form IIIB:

It should contain the estimate as well as the actual sources and use of fund for the half year

ended.

Borrowers with a credit limit of more than1 crore are required to supply the quarterly

information.

The bank to follow up and supervise the use of credit should properly use the information

supplied by the borrower.

The bank must ensure that the bank credit was used for the purposes for which it is granted,

keeping in view the borrowers operation and environment.

The bank should confirm whether the actual result is in conformity with the expected

results. A+/- 10% variation is considered normal.

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The banker should be treated as a partner in the business with whom information should be

shared freely and frankly.

The recommendations of the Tandon committee have been widely debated and criticized.

The bankers have found a difficult to implement the committees recommendations.

However, the Tandon committee has brought about a perceptible change in the outlook and

attitude of both the banker and their customers. They have become quite aware in the

matter of making the best use of a scare resource like bank credit. The committee has help

in bringing the financial discipline through a balanced and integrated scheme of bank

lending. Most of banks in India, even today continue to look at the needs of the corporate

in the light of recommendation of the Tandon committee

CHORE COMMITTEE

INTRODUCTION

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In April 1979, the RBI constituted a working group to review the system of cash credit

under the chairmanship of Mr. K. B. Chore, Chief Officer, DBCOD, RBI. The main terms

of reference for the group were to review the cash credit discipline and relate credit limit to

production.

RECOMMENDATION OF CHORE COMMITTEE: -

Bank credit: -

Borrower should contribute more funds to finance their working capital requirement and

reduce their dependence on bank credit. The committee suggested placing the second

method of lending as explain in the Tandon committee report.

In case the borrower is unable to comply with this requirement immediately, he would be

granted excess borrowing in the form of working capital loan (WCTL).

The WCTL should be paid in seamy annual installments for a period not exceeding 5 years

and a higher rate of interest than under the cash credit system would be charged.

This procedure should apply to those borrowers, having working capital requirements of

more than Rs 10 lacs.

LEVEL OF CREDIT LIMIT

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Bank should appraise and fix separate limits for the peak level and normal non pick

level credit requirements for all borrowers in excess of Rs. 10 lacs indicating the relevant

periods.

With the sanctioned limits for these two periods, the borrower should indicate in advance

his need for funds during the quarter. Any deviation in utilization of funds Beyond 10%

should be considered irregular and is subject to penalty fix by the RBI (2% p.a. over the

normal rate)

Bank should discourage ad hoc or temporary credit limits. If sanction under exceptional

circumstances the same should be given in the form of a separate demand loan and

additional interest of at least 1% should charged.

Lending system:

The system of three types of lending should continue i.e. cash credit loan and bills

wherever possible; the bank should replace cash credit system by loan and bills.

Bank should scrutinize the cash credit accounts of large borrowers ones a year.

Bifurcation of cash credit account into demand loan fluctuating cash credit component, as

recommended by the Tandon committee should discontinue.

Advances against books debts should be converted to bills wherever possible and at least

50% of cash credit limit utilize for financing purchases of raw material inventory should

also be charged to the bill system.

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Information System

The discipline relating to the submission ofQuarterly Statements to be obtained from the

borrower should be strictly adhered to in respects of all borrowers having working capital

limits of more than Rs.50 lacs.

If the borrower does not submit report within the prescribed time, he should be penalized

by charging a penal rate of interest, which is 2% p. a. more than the contracted rate.

Banks should insists the public sector undertakings and large borrower to maintained

control accounts in their books to give precise data regarding their dues to the small units

and furnish such data in their quarterly reports.

Other recommendations:

Request for relaxation of inventory norms and for ad hoc increases in limits should be

subjected by banks to close scrutiny and agreed only in exceptional circumstances.

Delays on the part of the banks in sanctioning credit limits should be reduced in cases

where the borrowers cooperate in giving the necessary information about their past

performance and future projection in time.

Autonomous institutions on the lines of the discount houses in U.K may be set up to

encourage the bill system of financing and to facilitate all money operations.

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There should be a cell attached to the chairmens office at the central office of each bank

to attend to matters like immediate communication of credit control measures at the

operational level.

The central offices of bank should take a second look at the credit budget as soon as

changes in the credit policy are announced by the RBI and they should revised their plan of

action in the right of new policy and communicate the corrective measures at the

operational levels at the earliest.

Bank should give particular attention to monitor the key branches and critical accounts.

The communication channels and system and procedures with in the banking system

should be toned up so as to ensure that minimum time is taken for collection of

instruments.

FINANCIAL RATIOS

CURRENT RATIO=CURRENT ASSET/ CURRENT LIABITIES

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Help to measure liquidity and financial strength, indication of availability of current assets

to pay current liabilities. The higher the ratio betters the liquidity position. Generally it

should be at least 1.33.

TOL/TNW=TOL/TANGIABLE NET WORTH

Indicate size of stakes, stability and degree of solvency. Indicates how high the stake of the

creditors is. Indicate what proportion of the company finance is represented by the tangible

net worth. The lower the ratio, greater the solvency. Anything over 5 should be viewed

with concern.

The ratio should be studied at the peak level of operations.

OPERATING PROFIT RATIO=OPERATING PROFIT/NET SALES100

This ratio indicates operating efficiency. Indication of net margin of profit available on Rs.

100 sales. Trend for company over a period should be encouraging.

DSCR(DEBT SERVICE COVERAGE RATIO)=DEPRICIATION+INTREST ON

TERM LOAN/ INTREST ON TERM LOAN+INSTALLMENT OF TERM LOAN

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It indica

Working Capital Requirments

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Transcript of Working Capital Requirments